What's wrong with centralized crypto lending?

What's wrong with centralized crypto lending?

Given the ongoing volatility and liquidity concerns in the market, some in the crypto lending industry may want to rethink their structures and practices. After a market collapse with bankruptcies at Three Arrows Capital, Voyager Digital and most recently Celsius, measures to better protect customers are essential.

On the one hand, Voyager's bankruptcy has significant consequences for its customers - considering that the user agreement did not really guarantee the protection of their funds. But this doesn't apply to every crypto lender; Each likely has different user agreements and operates in unique ways in terms of how account holders are treated.

Customers who are at risk of becoming creditors with unsecured claims

Daniel Besikof, a partner at the law firm Loeb & Loeb in New York, said that's how Voyager treats its account holders unsecured creditors.

“The way the [user] agreement specifies how the assets are held and how the company actually holds or uses those assets are the key data points in determining how those assets are likely to be treated in bankruptcy,” he told Blockworks in an interview.

In retrospect, he said Voyager's business model was difficult for him to justify. “They essentially lent customers’ deposits to just a small handful of borrowers, the largest of which is [Three Arrows Capital], obviously with little collateral coverage.”

Besikof added that most customers may not have understood that they were signing up for a higher level of risk than simply investing in cryptocurrency assets.

"I don't think many of these customers realized that Voyager itself was perhaps an even greater investment risk because the customers' assets were being lent to people for whom the customers presumably had not purchased insurance," he said.

It may also have been the case that the lender did not explicitly state the exact risks and was not clear that crypto funds would be considered the property of the bankrupt estate if it had to go through bankruptcy proceedings.

Celsius customers are probably facing the same problem. The companies Terms of Use stipulate that depositors' high-interest "earn" accounts include a transfer of ownership of their funds to Celsius. The company not only manages customer funds on behalf of depositors.

In the future, Besikof expects investors to choose alternative custody methods such as hardware wallets and off-chain storage solutions.

“Off-chain storage solutions could and probably should become more popular because that way customers can at least minimize the risk of exchange bankruptcy,” he said, adding that some less secure exchanges might have a hard time finding savvy customers.

Verification of the percentages of funds lent and borrowed

Daniel Tal, a leader at decentralized finance project ICHI, told Blockworks that the current market downturn has exposed gaps in some projects, but it is also a time for users and developers to create new protocols that improve on existing models.

“This space is still somewhat experimental, and we are continually learning where to invest, how to invest in a safe way,” Tal said.

Due to the industry's emergence, regulators still haven't had the time to identify problems in the system. This is probably because intelligent regulation should come from people who understand the space and how it works.

Crypto lending is similar to traditional lending but involves digital assets. However, some commentators say the high returns promised by platforms like Celsius are not sustainable. They may also be a misnomer - because excessive returns are more of a bet than a real return - unless lenders are transparent about how they can deal with them.

Lending and borrowing platforms provide minimal information about where the funds they borrow go.

There should be certain risk parameters for large companies depositing funds from a centralized Web2 space into decentralized finance (DeFi) protocols, such as: B. Audits of the percentage of funds lent or borrowed, Tal suggested.

“We've seen these deleveraging events where people... have taken on more than they can handle,” Tal said. "Models need to be built to be sustainable in the sense that they move away from a derivative perspective to eliminate the risk of volatility. I think that is one of the biggest risks in exchanging and collateralizing these funds."

The blockchain developer pointed out how traditional loans work: If you want to secure a bank loan to buy a Toyota Camry, you would not only have to offer an asset as security in the event of default, but also provide an explanation as to why you need that money. The crypto lending space could take a cue from this example, where secure liquidity strategies allow customers to know where their funds will end up.

For him, there are currently no best practice models in the credit sector. "I don't think anyone is doing it in a safe way. What is possible is being able to manage people's credit in an intelligent way - and that needs to be built."

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The post What's Wrong With Centralized Crypto Lending? is not financial advice.