Original Title: "Crypto Lending and Its Impact on the Market"

Original Author: Carrie | Chain Hill Capital

This article was written by Carrie, the managing partner of Chain Hill Capital and head of the index fund. Unauthorized reprinting is strictly prohibited. For reprinting, please refer to the title format shown in the "Reprint Instructions" and contact Chain Hill Capital. , the following is the body part:

1. Overview of the lending market

1. Basic introduction

In the most common form of crypto lending, borrowers use their crypto assets as collateral to obtain fiat or stablecoin loans, while lenders earn interest income by providing assets. Another way is for borrowers to borrow crypto assets using fiat or stablecoins as collateral, but this is rare. The market demand for encrypted lending comes from the following aspects:

ØTrading activities– Including arbitrage, leverage, market making and other trading activities, which is the most important requirement. For example, OTC service providers or market makers need to borrow funds to meet a large number of transactions; traders use borrowing to increase leverage, or borrow assets to short sell for arbitrage;

ØTax optimization– At present, many countries and regions include the sale of encrypted assets as a taxable event. Depending on the jurisdiction, the tax rate may be as high as 40% to 50%. (Data source: CNBC) Therefore, if you directly sell encrypted assets, you need to pay high capital gains tax, but you only need to pay about 10% interest per year through encrypted lending;

Ø Earn passive income– This situation is suitable for investors who want to hold encrypted assets for a long time and at the same time want to increase additional income (interest);

Ø Access to working capital– By mortgaging encrypted assets to borrow legal currency, miners, ICO teams and encrypted start-ups can solve short-term liquidity needs while retaining the future potential upside value of their cryptocurrency investment;

ØToken economyimage description

Encrypted lending flow chart

There are many structural differences between the encrypted lending market and the traditional lending market (banks, online lending, etc.).

There are two types of encrypted lending: centralized lending and decentralized lending.

(1) Centralized lending

This is an escrow-based lending, the main feature of which is that users cannot control their own assets, and the user's private key is controlled by the platform. Specifically, users must deposit their crypto assets into the platform wallet. The platform either lends out the user's assets through a peer-to-peer model, or merges the assets and then lends them to the counterparty through OTC. In the case of borrowers, the platform locks their assets as collateral and lends them fiat or stablecoins. Depending on the operating strategy of the platform, some platforms will use the user's mortgage assets for loans. Borrowers obtain encrypted assets, stable coins or fiat currency through the lending platform. When the borrower fails to repay the loan, its collateral will be liquidated. According to the type of users targeted, centralized lending can be divided into two categories: personal lending and institutional lending.

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2. Industry Status

The most important event in the first quarter of 2020 is the impact of the new crown epidemic on the entire encryption market. In the face of unprecedented market volatility, the encrypted lending market has shown good resilience. The liquidation rates of centralized lending institutions and DeFi lending are less than 10% and 20%, respectively. With the rapid recovery of the encryption market, the growth of the encryption lending industry accelerated in the second quarter, and both the assets invested by investors and the overall number of users have experienced a substantial increase.

In the second quarter, the amount of active lending (referring to loans that have not yet been repaid) across the industry increased by 100% to nearly US$5.2 billion, and the value of collateral assets increased by 98% to US$10 billion. Even after adjusting for underlying asset price increases, there is still a significant increase in mortgage assets of about 50%. The growth in Q2 was largely driven by growth in products for individuals (Blockfi, Nexo, Celsius, Compound) and the launch of a more robust derivatives trading platform for institutions (Genesis).

The growth of the DeFi lending sector is more obvious, with active lending increasing by 252% and collateral increasing by 183%. This is because:

Data source: Credmark, these data cover Defi lending and 85% of centralized lending

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Data source: defipulse

Data source: genesis

Data source: Credmark

Data source: Credmark

Data source: Credmark

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Data source: Credmark, Chain Hill Capital

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Data source: loanscan

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Data source: bankrate

Loan-to-value (LTV) ratios for crypto lending have generally changed little over the past year. Although the LTV of DeFi lending has increased, it is still the lowest at about 32%; the LTV of centralized lending is about 55%.

The reason why the LTV of DeFi lending is far lower than that of the central crypto lending platform is:

1) The risk control mechanism is different.Due to the anonymity of the DeFi platform, it is impossible to verify the real identity and credit of the user, coupled with the high volatility of the encryption market and the relatively low liquidity of the DeFi trading platform, therefore, it is necessary to ensure that the lender needs a higher LTV security of funds. In contrast, centralized lending platforms can reduce the risk of default through comprehensive due diligence. For example, BlockFi will verify the assets of the counterparty and require the counterparty to have 20 years of experience in financial transactions.

2) Market demands are different.Data source: Credmark

Data source: Credmark

Data source: Credmark

Data source: Credmark

3. Problems to be solved

(1) External problems

Centralized platform moral hazard.Because users' assets are hosted on the platform, and encrypted lending platforms are not subject to supervision and insurance protection like banks (some platforms have custody insurance), the moral hazard is relatively high. The recent bankruptcy of the centralized lending platform Cred is a good example. Cred committed serious fraud and misuse of funds. They first lent client assets to usury institutions, and invested the remaining funds in encrypted hedge funds. In the market on March 12, the hedge funds they invested in closed down. In order to deal with the financial loopholes, they borrowed money from loan sharks to invest in hedge funds, but platform executives stole part of the funds. In the end, Cred filed for bankruptcy with assets valued at between $50 million and $100 million and liabilities between $100 million and $500 million. In addition, many centralized lending platforms have a re-mortgage business model, which requires high risk management capabilities of the platform. In the absence of regulatory constraints, excessive lending is likely to occur, eventually forming a systemic risk.

technical risk.Smart contracts are relatively new technology, and transactions recorded on the blockchain are irreversible. Therefore, when using smart contracts to transfer funds and manage lending contracts, errors can cause irreparable losses. Moreover, many projects and codes have not passed strict inspections, and once there are loopholes, they will be exploited by hackers. According to CipherTrace’s report, as of the end of October, losses from theft and hacking (excluding misappropriation and fraud) this year totaled $468 million, and about 20% of these hacking attacks (about $98 million) came from DeFi.

regulatory risk.The open and permissionless nature of DeFi makes it not subject to geographical restrictions, and people in any country/region can access and use it without authentication. This means that it is difficult to have applicable regulations to regulate it. Therefore, many people think that DeFi may become a paradise for money launderers. Indeed, in the face of a brand new thing, regulators still need time to explore suitable regulatory solutions, and the current scale of DeFi may not be enough to attract regulatory attention. However, once the industry takes off, it is highly likely that regulators will start paying attention to DeFi risks. For DeFi lending (and the entire crypto industry), regulation is always a potential risk.

(2) Intrinsic problems - product limitations

According to the credit degree of loans, commercial bank loans are currently divided into four types: credit loans, guaranteed loans, mortgage loans, and pledged loans. Except for credit loans, the latter three are collectively called secured loans. Credit loans have a high degree of credit, do not require mortgages and third-party guarantors, and are only issued based on the credit of the lender. The biggest difference between a secured loan and a secured loan is whether a mortgage or a third party guarantee is required. These two forms of lending complement each other to meet different needs.

Based on the data in the mid-term report of 2018, the proportions of the four kinds of loans in my country's listed banks are 42% for mortgage loans, 30% for credit loans, 17% for guaranteed loans, and 11% for pledge loans. That is to say, credit loans account for 30% of listed bank loans.

As mentioned earlier, due to the lack of user credit scores and KYC, DeFi lending can only control risks through over-collateralization. The current mortgage rate is about 350-700%, which means that users may need to mortgage up to 700 units of crypto assets to borrow 100 units.

Of course, DeFi lending can do a lot with the concept of mortgage lending alone. According to the May 2020 report of the Federal Reserve Bank of New York, the scale of mortgage loans in the United States is 14.30 trillion US dollars. However, the current collateral for DeFi loans is very limited, and can only be used as collateral through encrypted assets.

In short, if the problems of high mortgage rate and asset restrictions can be solved, DeFi lending or blockchain-based lending will have more application scenarios and user groups.

4. Development trend

In addition to the gradual improvement of regulation and the maturity of technology, the encrypted lending market may have the following development trends.

(1) The product gradually matures

For example, Aave pioneered the unsecured loan model "Flash Loans", which is designed for developers to make loans immediately without providing any collateral, provided that the borrowing and interest must be combined in the same transaction. Return, the whole process should be completed in one Ethereum block (15 seconds).

In addition, with the resolution of blockchain cross-chain information transmission technical problems and the development of oracle technology, interconnected blockchain networks can realize cross-platform seamless sharing and ID access to verify users' credit records and identity certificates , income and employment proofs, so as to establish blockchain-based credit proofs for users, and introduce real assets as collateral. Oracles like Chainlink already allow the blockchain to have a two-way conversation with off-chain data sources. Some cryptocurrency lending platforms have integrated Chainlink, and borrowers can use cars, real estate and other off-chain assets for collateral in the future.

Through these developments, DeFi lending can realize credit loans and mortgage loans other than encrypted assets, and its product form and user scale will be further developed.

(2) Integration with traditional markets

Even disregarding the yield gap between crypto assets and traditional assets, the high interest rates and relative safety of crypto lending may be enough to attract more institutional players into the space. In the case of Genesis, its institutional lender customers grew 47% at the end of the third quarter and were up 275% from a year earlier.

DeFi may continue to exist as an independent, emerging market for a long time to come. But in the end, the creativity of smart contracts will affect the traditional lending market and be applied by traditional institutions and platforms, forming a combination that not only retains the advantages of centralized institutions, but also provides some functions of decentralization.

2. The impact of the lending market on the market

1. Positive impact

1.1 Increase the attractiveness of encrypted assets

Data source: Charles Schwab

BlockFi, a leading centralized crypto lending institution, made another interesting statistics. They collected data on interest accounts with balances between $5,000 and $10 million on their platform. Two phenomena were found:

1) All users own non-stablecoin encrypted assets far more than stablecoins, and Bitcoin is the most popular;

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Data source: BlockFi

These two sets of data may indicate that lending platforms such as BlockFi are more attractive to baby boomers to hold encrypted assets than financial service providers. The stable currency provides an investment similar to the high-yield treasury bonds in the 1980s, allowing investors to have access to the encrypted market other than holding highly volatile encrypted assets. Stablecoins on lending platforms are mainly used to fund crypto-asset mortgage loans such as Bitcoin. Taking BlockFi as an example, lenders can obtain 8.6% APY. Compared with the APY of less than 0.5% on bank deposits, this is undoubtedly hugely attractive. Therefore, stablecoin loans collateralized by highly liquid crypto-assets will be popular with high-net-worth individuals (baby boomers), family offices, and investment fund portfolios. These groups will provide more capital and liquidity to the crypto ecosystem, helping Generation X, Millennials, and Generation Z to carry out productive economic activities, including starting a business, buying real estate, and buying more crypto assets.

For investors who have recognized encrypted assets, if they can obtain additional interest income while enjoying potential capital gains by holding encrypted assets, their interest in holding encrypted assets will also be stronger. In conclusion, the lending market is conducive to attracting more potential investors into the crypto asset industry.

1.2 Establish a more mature encryption market infrastructure

At the beginning of the article, it was mentioned that the biggest demand for encrypted lending comes from transactions. Many traders and investors increase their crypto holdings by borrowing cash or another crypto asset as collateral. This effectively introduces leverage, adding additional liquidity. Lending provides another way to short the market. If the lending platform can improve its functions to make short selling as simple as trading futures, then short selling will be more widely used and promote market price discovery.

Therefore, lending solutions can assist market makers, arbitrage transactions, and other important market activities, thereby helping the entire crypto market to increase liquidity and reduce market volatility. For traditional financial markets, margin trading and leverage are key infrastructures, and encrypted lending can better improve this market infrastructure, thereby attracting more investors, especially institutional investors. The entry of more investors will further increase the liquidity of the encryption market and reduce market volatility, thus forming a virtuous circle.

The centralized lending platform also provides alternatives to exchanges for users who need to liquidate or do not want to hold positions, allowing users to achieve their goals without selling their encrypted assets, and it also has the effect of tax optimization.

2. Potential risks

It has been argued that the growth of the crypto lending market will lead to an over-financialization of the market, as the issuance of securities through multiple layers of claims and securities based on these bonds will increase the supply of crypto assets in circulation and affect the nature of ownership and the rights of original holders. destroy. This model of mortgaging encrypted assets to borrow funds and buying more encrypted assets will continue to amplify the leverage of the market, and if it develops to a certain extent, it may form a systemic risk. When the market falls, if investors fail to liquidate their multi-layered positions in a timely manner, it may lead to the collapse of the lending platform and amplify market volatility.

This concern is not unreasonable, because encrypted lending is essentially the same as traditional lending, and moderate leverage must be maintained in order to operate healthily. But for now, encrypted lending is still dominated by excess borrowing, which does not meet the above-mentioned systemic risk conditions.

Supported by a professional team with multicultural backgrounds, members of the core departments - Investment Research Department, Trading Department, and Risk Control Department are all from well-known universities and institutions at home and abroad. They have a solid financial background, excellent investment research capabilities, and a keen sense of the market Sensitive ability, highly awe of the market and risks. The investment research department combines rigorous basic research with mathematical and statistical models to obtain investment strategies such as "Pure Alpha" and "Smart Beta".

References

1.https://sncrating.com/cn/report/686

2.https://reports.credmark.com/TheCryptoCreditReport-q4-2019.pdf

3.https://www.youhodler.com/blog/crypto-lending-vs-bank-lending

4.https://www.coindesk.com/wp-content/uploads/2020/01/CryptoLending101_CoindeskResearch.pdf

5.https://www.bankrate.com/banking/cds/cd-rates/

6.https://finance.sina.cn/zl/2019-03-27/zl-ihtxyzsm0945332.d.html?vt=4&cid=79615

7.https://blockfi.com/blockfi-boomers-say-ok-to-bitcoin

About Chain Hill Capital

Since its establishment in 2017, Chain Hill Capital (Qianfeng Capital) has focused on the value investment of global blockchain projects. It has created early-stage and growth-stage equity investments and encrypted digital asset investment matrices of Alpha Strategy and Beta Strategy. Global resource relationship network, strategic layout of Chicago, New York, Tokyo, Beijing, Shanghai, Shenzhen, Hong Kong, Xiamen and other city nodes. With a wealth of overseas investment institutions and a global high-quality project resource pool, it is an international blockchain venture capital fund.

Supported by a professional team with multicultural backgrounds, members of the core departments - Investment Research Department, Trading Department, and Risk Control Department are all from well-known universities and institutions at home and abroad. They have a solid financial background, excellent investment research capabilities, and a keen sense of the market Sensitive ability, highly awe of the market and risks. The investment research department combines rigorous basic research with mathematical and statistical models to obtain investment strategies such as "Pure Alpha" and "Smart Beta".