Author: Edic, Phil, 1Token
Lending has been one of the core fundamental financial services provided by institutions like commercial banks by matching the market supply and demand of fixed income and liquidity in an economy. In 2022, the global debt market is expected to reach US$7.83 trillion, seeing a YoY increase of 10.8% from US$7.07 trillion in 2021. Moreover, this figure is expected to reach US$11.29 trillion in 2026 .
Admist the surge of global debt, crypto lending is growing at an impressive rate as an emerging sector. As Genesis Trading, one of the main market players, published in their 2021 Annual Market Insights Report , its cumulative loan book has exceeded $15 billion between March 2018 to the end of 2021, an increase of approximately 829% YoY compared to the $2 billion at the end of 2020.
While crypto-native lending institutions such as Anchorage, BlockFi, Celsius and Nexo continue to expand, traditional financial institutions are also entering the crypto lending business. For example, Goldman Sachs issued its first fiat loan on bitcoin as collateral in April 2022.
Recently (June 2022), two top ranked crypto lending institutions, Celsius (one of the major net lenders in crypto market) and Babel Finance (one of the major net borrowers in crypto market), have announced restrictions on user withdrawals due to the market liquidity crisis triggered by UST and stETH depeg, raising industry-wide skepticism on crypto lending institutions’ operations management and risk control practice.
As a veteran in traditional financial infrastructure and nowadays a key end-to-end software vendor in crypto lending, 1Token team prepared this article to share experiences and insights on how to thrive in the crypto lending industry, covering key points in crypto lending firms’ operations, risk, and treasury management.
What is Crypto Lending?
Crypto lending refers to the scenario, where the lenders issue loans to the borrowers based on the borrowers’ credit and / or collateral (either collateral or loan being cryptocurrency). The borrowers shall repay the principal within a specific period and pay interests at a certain frequency according to the term sheet.
Lenders and borrowers can be single or a group of individuals (‘C’ for customers) or institutions (‘B’ for business), where lenders provide sources of capital and borrowers provide allocations of capital.
The initial sources of capital usually come from the central bank and individual customers. In crypto lending, stablecoin issuers like Tether play the role of central banks, and exchanges / lending platforms / DeFi protocols play the role of commercial banks that offer Earn / Lending programs to individuals.
On the other hand, the final allocation of capital in crypto lending typically goes to institutions like Quant traders, POW coin miners, or individual customers that are HODLer who seek short-term liquidity.
To help match those capital from their initial sources (lenders) and the final allocations (borrowers), brokers / dealers make profit by providing financial services and taking commission / interest.
Brokers run matched loans, where the size and term of the loan from the lender matches 100% with the loan to the borrowers. While dealers maintain a cash pool consists of lenders’ capital and borrowers’ collateral, usually managed by their treasury departments. As longer fixed term loans can generate higher yield and ensure capital utilization, there will be term maturity mismatch where their assets are more illiquid than their sources of capital.
Compared to brokers, dealers earn higher yield but more complexity and risk in their business model as they need to manage cash flow and allocate idle capital into other assets than loans, such as staking in other CeFi and DeFi counterparties. So dealers normally set up the treasury department and various business / investment desks, where the treasury plays a central dispatcher role by lending capital into internal desks. And those desks allocate the assets into their area of investments and even lend extra capital back to the treasury. We will further elaborate this in the future articles about Treasury Management.
Purpose of Crypto Lending Participants
What is the role and purpose of those participants in the crypto lending ecosystem? Here is an example.
1. A group of investors participate in the ‘Earn’ program from crypto lending institution A (typically a financial service platform or crypto exchange) with 1 million USDT, which might be 5% APY fixed term for 1 year, or 2% APY open term. The asset received from the investors is managed by A’s treasury department.
2. Crypto institution B seeks a 6 months loan of 1 million USDT from A’s Trading desk, so A’s trading desk applies to the treasury for capital.
3. A’s treasury department decides to lend 1 million USDT to A’s trading desk after analysis, the internal term is set as 0.5 year fixed and 10% APY. Since there is a mismatch in the maturity of the ‘Earn’ product and loan, treasury needs to manage the liquidity of USDT to meet potential redemptions.
4. A’s trading desk lends the aforementioned 1 million USDT to B, with 8% APY and fixed term 0.5 year, in return B posts 1,500 ETH (assume ETH spot price is $1,000 USDT) as collateral.
5. B uses the capital for trading and hedging, with 12% APY.
6. A’s trading desk gets 1,500 ETH as collateral, trading desk will stake ETH in another ETH staking platform for 2-5% APY open term.
Meanwhile, A might lend to more crypto lending institutions for interest, who may also lend the asset in the same way for the same purpose. Through one or multiple crypto lending institutions, the sources of capital would flow to the final borrowers.
Purpose of Lenders
The main purpose of lenders is to earn yield, who are usually risk-averse. Institutional lenders tend to issue fixed-term and fixed-rate loans, while retail lenders prefer to invest or lend in a more flexible way (short-term or open term) even though this means a lower yield.
Purpose of Broker / Dealers
As intermediary institutions bridging the borrowers and lenders (Crypto lending institution A above), broker / dealer major purpose is to earn net interest margin by borrowing low and lending high at maximized capital utilization.
Those large brand names like Anchorage, BlockFi, Celsius, Genesis are dealers, while typical brokers are yield funds who run back-to-back loans that supply fixed income capital to dealers.
Purpose of Borrowers
Borrowers typically have higher yield generation capabilities, and are willing to take higher risks (Crypto Institution B above). Typical examples are asset management institutions (such as Alameda Research) and POW coin miners. Specifically, their common purposes include:
(1) Leverage up for higher return. Borrowers leverage up through loans  to trade with higher buying power, therefore higher returns on their principal. Leveraging up via crypto lending amplifies the profit and loss, meanwhile avoiding the risk of forced liquidation by the exchange in arbitrage trading.
(2) Risk hedging. Through crypto lending, borrowers can borrow capital for risk hedging while holding their positions, which helps them avoid holding extra long positions.
(3) Short-term liquidity: Borrowers can borrow fiats to solve their short-term liquidity demands while holding their coin position in collateral. For example, crypto miners may borrow fiats using BTC as collateral to pay their utility bills.
Types of Crypto Lending
Crypto lending can be classified by lending venues, credit rating, collateral types and counterparties.
By Lending Venues
Crypto lending could happen in both centralized (CeFi) or decentralized (DeFi) venues. Currently, the share of centralized crypto lending exceeds 90% of the crypto lending market size.
CeFi venues are mainly exchanges and lending platforms. Exchanges (such as Binance, FTX, etc.) are the most accessible lending places for individual lenders. Lending platforms in this article refer to those lending platforms or financial service platforms. Loans from exchanges are often required to be used only in the exchange, while loans from lending platforms can be moved among different venues so they are more flexible and often used for institutional players. Currently, there are multiple leading CeFi lending platforms in the market, such as BlockFi, Celsius, Nexo, etc..
There is an active inter-institutional lending network which is used when some lending institutions have a temporary liquidity gap, or the treasury departments want to make arbitrage on interest rates. However, under the recent liquidity crisis triggered by LUNA / UST, stETH and GBTC, the redemption by panic lenders forced institutions to withdraw their allocations, causing a liquidity crisis for the whole crypto lending market.
DeFi venues are protocols built on blockchain-based smart contracts. So far, most DeFi protocols (such as Compound, AAVE, BenQi…) implement the cash pooling model to achieve the rapid matching of loans and real-time adjustment of loan interest rates, while very few protocols are in the broker model like Maple Finance.
One key difference between CeFi lending and DeFi lending is on the service. DeFi lending protocols can be lower in interest rate than CeFi, but the terms are too rigid for borrowers, such as initial and maintenance LTV, and no buffer time before forced liquidation.
By Credit Rating
As bank loans can be divided into credit loans and secured loans (including credit enhancement measures like mortgage, pledge, etc.), crypto lending can be similarly categorized as unsecured and secured loans.
Lenders normally lend to borrowers based on collateral, but some borrowers with strong track record and good reputation can borrow under or even without collateral within a credit limit, which can either be a formal loan agreement, or an earn program for investment.
For borrowers with relatively weaker credit (individuals, small institutions, etc.), the most common way is secured loans by posting collateral over the loan.
Besides the collateral loan (or bilateral loan), there’s another way of loan by DMA prime brokerage service (PB), where PB provides trading accounts of centralized exchanges funded with loans to the borrowers (usually quant traders). The borrowers should provide and keep certain collateral in the trading accounts, and pay trading fees and interests to PB. It is a common way in the market for asset managers to leverage up and get lower transaction fee rates in exchanges. We will publish articles to discuss Crypto Prime Brokerage business in detail in the future.
By Collateral Types
There are generally two types of collateral in the market for crypto lending: Standardized and Non-standardized collateral.
Cryptocurrency itself, with the characteristics of strong liquidity, is always accepted by lenders as standardized collateral. In most cases, stablecoins are usually borrowed using large-cap cryptocurrencies such as BTC and ETH as collateral. And stablecoins such as USDT and USDC might be pledged to borrow non-stablecoins in rare cases.
Non-standardized collateral refers to the collateral that is not cryptocurrency. As long as the borrowers and lenders reach an agreement, those crypto assets like blockchain and DeFi assets (DeFi AMM LP tokens, blockchain addresses, etc.), mining machines, NFT or even SAFT, can be used as collateral for loans. For example, Nexo recently issued a loan of 1,200 ETH by receiving two CryptoPunks Zombies NFT as collateral. The interest rate of this 60-day loan was 21% P.A.. The interest rate is much higher than the market average to cover the high risk in collateral value (NFT).
Depending on who they lend to, crypto lending institutions can be divided into to-B (Business) and to-C (individual).
To-B lending institutions means their sources (lenders) and allocations (borrowers) of capital are both strictly from institutions. Leading players are Anchorage and Genesis.
For to-C lending institutions, there might be both individual and institutional as their lenders and borrowers. Leading players are BlockFi, Celsius and Nexo. To-C crypto lending institutions usually face higher requirements in regulations. In February 2022, BlockFi was fined 100 million USD by SEC for ‘failing to register the offers and sales of its retail crypto lending product’.
How to Build A Crypto Lending Business
Crypto Lending Procedure
Crypto lending institutions use similar procedure like traditional lending:
Key Factors of Success
Risk Control (pre- or post-loan issuance) is definitely the core of lending business.
In the crypto loan business, institutions tend to focus on post-loan issuance risk control, i.e. collateral management.
Optimized Lending Solution
For lenders to attract borrowers, cost of capital (interest rate) is definitely the most important factor. While borrowers also care about other service features, like liquidation mechanism, cross-order collateral management…
Better service to borrowers might mean higher risk for lenders, so lenders have to balance the risk and service level, and seek support from various financial tools to protect their downside.
Risk Control Overview in Pre- and Post- Loan Issuance
The lenders are exposed to two major risks. The credit risk of borrowers not fulfilling the obligations to repay the principal and interest, and the collateral depreciation risk, which means the value of collateral drops lower than the total principal and interest.
Below table shows the main measures to address those risks.
Counterparty Rating and Credit Limit Setting
Lenders know their borrowers by due diligence on the borrowers’ business and financial status.
However, credit rating is more subjective than objective in the crypto industry, simply because financial reporting and auditing of crypto institutions is not as regulated and solid as traditional companies. Those large and well-known institutions might be rated higher than they should be and get over-leveraged. (LUNA / UST as a recent example)
Credit line can be set either in notional (loan value) or exposure (collateral value) terms.
Crypto lending institutions can be regarded as banks or security issuers in some jurisdictions, especially those to-C institutions, thus requiring a license to conduct business to local clients.
There were cases of leading to-C crypto lending institutions like BlockFi and Celsius being fined for to-C lending business, but no such case from to-B institutions like Anchorage and Genesis.
KYC and AML are also important to ensure the counterparties are using capital for purposes complying with the regulations. Nowadays travel rules are rolled out in different jurisdictions.
Counterparty Operating Status Tracking
In the post-loan stage, lenders need to track the borrower’s credit status and regularly evaluate the rating and credit line through the latest operating status, financial conditions, etc., to make sure their counterparty has the ability to repay the agreed principal and interest.
The target of collateral management is to ensure the value from disposal of collateral can cover the principal and interest. Most institutions track LTV (Loan-to-Value, has to be <100% to keep collateral more valuable than loan, and usually starts from 60-65% in secured loans), some others prefer to use collateral coverage ratio which is the inverse of LTV (so this has to be >100% and usually starts with 150-160% in secured loans)
The collateral in traditional lending includes ‘liquid assets’ (stocks, bills, etc.) and ‘illiquid assets’ (real estate, land use rights, etc.). For ‘liquid assets’, licensed financial institutions usually use public market price as the valuation of collateral. For ‘illiquid assets’, financial institutions usually hire professional 3rd party agencies to evaluate fair market value. In the post-loan stage, it’s easy to monitor value and liquidate liquid assets, and difficult to handle illiquid assets.
In the crypto lending market, most popular collaterals like BTC and ETH are extremely liquid. Those trading markets (exchange and OTC) operates 7*24 non-stop. Therefore, compared with traditional lending, post-loan collateral disposal in crypto lending is easy.
However, since the volatility in crypto price is much higher than in the traditional securities market, lenders have to monitor the real-time value of collateral and take actions when certain thresholds are reached. Only when the loan business scale is very small (e.g. limited loan orders, very simple collateral), it is possible for lenders to manually manage the collateral (setting alerts on crypto prices, manually sending margin calls or performing forced liquidations). After reaching a scale threshold, a software can manage the collateral in an efficient and scalable way. From 1Token’s experience with clients, this threshold is at 10-20 loan orders.
Nowadays, there are new non-standard collaterals in the crypto industry, which could fall into ‘liquid assets’ (AMM LP token, blockchain address) and ‘heavy assets’ (miners, VC investment ‘SAFT’, NFT).
Cash pooling model exposes lending institutions to liquidity risk.
When all liquid assets have been consumed to redemptions, the lending institution will have to get immediate liquidity either from short term borrowing (from other retail users, or from other institutions) or quit their position (stETH’s role in Celsius incident), with a cost that incurs negative effects to their profitability or even business continuity.
Treasury departments of to-C crypto lending institutions should take cashflow projection and asset liquidity ratio as high priority.
Crypto lenders need to know when they need to request further collateral for each order / borrower, or which price ranges are most ‘dangerous’ that trigger margin calls or forced liquidations for a large chunk of loan orders.
On the other hand, when collateral value increases with coin price, borrowers will apply to increase loan or withdraw collateral. Lenders should be able to simulate those scenarios and judge how to fulfill borrower’s request while still keeping a healthy LTV / collateral coverage ratio.
Maker-checker Approval and Audit Trail
Key operations through order lifetime require manual confirmation, e.g., when lender receives collateral from borrower’s exchange account, lender cannot automatically match the deposit to borrower so manual confirmation is necessary.
Functions like different user’s roles (maker/ check), approval process and operation log are required for large institutions to prevent mistakes, and provide necessary documentation to meet the standard from internal control and external auditors.
For financial reporting purposes, lending business data should be fed into accounting software like NetSuite and QuickBooks.
For the middle-back office, there are various analyses and reports for internal and external functions, across the company (Treasury view) or for each book / desk. Such as asset and liabilities, income and cost, asset liquidity, counterparty balance clearing and settlement, invoice and statements…
To generate such analysis with a spreadsheet is possible for a small lending scale. After reaching a scale threshold, a software is much more efficient and scalable, and an API connection or an export file that can be loaded into accounting software directly would save much effort.
Optimized Lending Solution
Lenders need to fully understand how borrowers operate with the loan and potential risks.
Within acceptable risk, lenders need to design the right terms (price and service) to attract borrowers with following considerations.
Price (interest rate) is decided by cost (sources of capital) and profit. Normally, whoever has lower cost can offer lower price to the market.
Main sources of capital can be (cost ranked from high to low) retained earnings, shareholder’s funding, external funds raised from earn programs, or borrowing from other institutions.
Generally speaking, crypto lenders expect higher yield than those in traditional finance, so nowadays crypto lending institutions are trying to seek funding from traditional finance by bridging their assets into the crypto industry, to reduce capital cost.
LTV (Initial LTV and Maintenance LTV)
There was a comparison on 2021 August between Nexo and Celsius , based on a Bitcoin collateral of $5 million worth, how much they can max. lend.
The max. loan is 4.5 million USDC on Nexo while 2.5 million USDC on Celsius.
If other terms are close, Nexo definitely has higher attractiveness to borrowers.
Cross-collateral means sharing collateral between orders.
It’s common between two counterparties to have multiple lending orders, with multiple coins in collateral and loan, and different entry prices. Sometimes there are other financial services between two institutions, such as OTC trading, structured products, and margin trading by DMA prime brokerage… To fit those scenarios, in crypto lending institutions there can be two-levels of cross-collateral mode.
– 1st level is to share collateral between multiple collateralized lending orders
– 2nd level is to share borrower’s equity / collateral among multiple business, including collateralized lending
Cross-collateral will be helpful to maximize borrower’s capital efficiency, but requires the lenders to precisely monitor risk across multiple orders and business.
Delayed liquidation means there’s a buffer time from 1st margin call till forced liquidation.
Normally this is only applicable in institutional lending, where there are two LTV levels of margin call. Let’s call them a) liquidation alert and b) liquidation execution.
a) Liquidation alert is usually at LTV 85-95% (depending on the collateral coin’s liquidity and loan size) where the lenders usually offer a buffer time up to 24 hours from margin call.
If borrowers wish not to be liquidated, they have to 1) respond to lenders’ margin calls and 2) show proof of capital abundance and deposit attempt. In a drastic market like March 12 2020, blockchain is jammed, and deposit could take several hours. So a transfer record snapshot can be acknowledged.
If the borrower fails to respond to margin calls or provide proof within agreed time, lenders will trigger liquidation to recover the loan.
b) Liquidation execution is usually above LTV 95% (sometimes can be above 100%) where the lenders will immediately liquidate collateral to cover the loan.
Different lenders might set different parameters and procedures about those two margin calls. And overall, this delayed liquidation mechanism is favored by borrowers due to flexibility.
In the current crypto lending ecosystem, we see potential for crypto lending institutions to enhance their competitiveness.
Real-time monitoring on market rates
If the optimal loan interest rate across different CeFi and DeFi venues can be monitored, sources of capital and assets in the market can be effectively connected. Moreover, financial institutions can carry out lending and arbitrage in the best place to improve their profitability. Currently, Paradigm has established a lending marketplace to match the RFQ of borrowers and lenders.
Non-standard collateral loans
As mentioned above, non-standardized collateral like NFTs and mining machines are already recognized as collateral in some cases. Lending institutions should establish a reasonable valuation mechanism for non-standardized collaterals based on market’s demand, so as to increase attractiveness to borrowers.
Here are some worthy considerations for setting up the standards: Instead of taking the floor price, is it possible to use the market price in Opensea (or other mainstream marketplaces) for NFT valuation? Should mining machines be valued based on market quotations, or total future cash flow, or even both?
Non-performing loans are inevitable for lenders, and the bad debt provisions will have huge impacts on lenders’ profitability.
The major risk to lenders is the market fluctuation, when the market crashes, the drop in collateral value dramatically increases the risk on the lenders’ side. So it is always good to hold certain positions of put options to remedy the potential loss caused by market plummet.
It will not be a surprise if in the future credit insurance instruments emerge in the crypto industry. For example, CDS (Credit Default Swap) which helps transfer the risk of credit default from lenders to a 3rd party. There are three parties in CDS transactions: the borrower, the lender (CDS buyer) and CDS seller (banks or insurance companies). Similarly In crypto industry, lenders can also pack the non-performing crypto loans and purchase CDS from banks or insurance companies, the risks therefore are mitigated and CDS sellers will get premium instead.
1Token’s One-station Financial Software for Crypto Institutions
Currently, 1Token software supports all crypto assets in CeFi and DeFi, including spots, futures, options, fixed / variable income products, SAFT, POW / POS mining, staking / yield farming, NFT etc., as well as traditional assets such as stocks / FX / ETFs etc.
1Token’s institutional clients spread across all verticals of crypto-finance, including buy-side institutions in asset management, fund / FoF / MoM, foundation / exchange treasury, fund admin, audit etc., and sell-side institutions in lending, margin trading, prime broke, retail brokerage, spot OTC, derivative OTC etc.
For each specific business vertical, 1Token provides an end-to-end solution that supports front-to-back office technology in sales & trading, OEMS, portfolio and risk management, pricing / product structuring, accounting, clearing & settlement etc., and multi-department usage for sales / trading / risk / operation / finance teams all at once.
Today, 1Token serves 40+ large global institutions, with top profiles like Algorand Foundation, Amber Group, FBG Capital, Matrixport, Metalpha, Pintu, Zipmex, and 4 of the Top 7 CMC exchanges etc., which in total exceed $20+ bn asset managed.
For crypto lending, 1Token CAM offers life-cycle management solution and treasury management solution for front-to-back office of crypto lending institutions, including:
1. Internally multi-department structure: Departmental or collective view of cash flow / balance sheets / profit & loss;
2. Internal lending: Cross-department loan order management and full record keeping;
3. Multi-dimensional analysis and reports: Cash flow projection, stress test, interest income and cost analysis, etc.
1. Counterparties Management: Borrower / Lender KYC information maintenance, Transfer confirmation, Credit limit setting, Regular billing and statements;
3. Loan Book Management: Order book keeping, Flexible loan term settings (interest rate, duration, collateral types, liquidation methods ), Loan contract maintenance.
Risk Management Department
1. Lending Dashboard: Chart dashboard analyzing loan business revenue, expenditure and risk structure, Stress tests simulation and Defensive measure effects (such as buying put options);
2. Risk Management: Collateral management at order, account and customer level (cryptocurrency, and other non-standardized collateral management), Automatic margin calls, liquidation alert and expiry alert (to internal and external relevant personnel through multiple channels, such as email, SMS, phone, Telegram, Slack);
3. Forced Liquidation: Liquidation order execution in CAM by placing orders to external counterparties (exchange or OTC) to close the positions when a pre-set risk rule is triggered.
1. Trade Reconciliation: Reconciliation of all transactions (spot and derivatives trades/ lending/ transfer..), Transaction logs export and reconciliation report generation;
2. Raw Data Export: Raw data support for accounting, audit, tax, and compliance reports, Market / assets snapshots for reporting purposes, Data integratable to accounting systems like NetSuite, Quickbooks.
1Token CAM Lending System supports on-premise local deployment for exchange-grade data security, BCP plan, various roles and permissions setup for different departments / user groups. Meanwhile, 1Token CAM provides API for users to connect, institutional services ready for partial module customization.
1. Lending Global Market Report 2022 – By Type (Corporate Lending, Household Lending, Government Lending), By Interest Rate (Fixed Rate, Floating Rate), By Lending Channel (Offline, Online) – Market Size, Trends, And Global Forecast 2022-2026
2. Genesis 2021 Q4 Market Observations
3. Arcane Research: Banking on Bitcoin The State of Bitcoin as Collateral
4. Nexo vs Celsius: A Comparison of Crypto Lending Platforms
5. The Crypto Credit Report, Issue 7, Q4 2020
6. VanEck research：Crypto Lending and the Search for Yield