As Compound Loses US$80M - We Look At Crypto-Lending

Over the course of the pandemic, the USD value of blockchain-based lending skyrocketed. Disruption to financial markets all over the world contributed to a loss of faith in fiat and many took refuge from the chaos in decentralised currencies. At the time of writing, the TVL(Total Value Locked) in crypto-lending sits at $40B. (Source: DeFi Pulse)

Forecasts expect the crypto lending space to continue to grow at significant rates throughout the decade and it would seem fair to say that the space has earned a spot amongst some of the most popular uses for digital currencies.

Is crypto lending really all that different from traditional lending however? In many ways, it is built upon the same fundamental principles as traditional lending - but some key points of differentiation are causing both lenders and borrowers to flock to it alike. Let’s take a look at why.

How it Works

Like traditional lending, crypto lending requires both a borrower and a lender (investor). A borrower desires a loan in a cryptocurrency and a lender seeks to earn interest or ‘passive income’ on a supply of cryptocurrency or stablecoins that they own. Borrowers will typically have to stake a proportion of their loan in the same crypto asset to allow the lender to recover some of their costs if it cannot be repaid. This proportion varies depending on the service being used but can be as little as 1% or as high as 50%.

Rather than interest - which is a rate at which the borrower is explicitly charged by the lender for their loan, lenders instead earn ‘yields’ for providing crypto liquidity. Yields represent the rate at which profits are earned by lenders - and vary greatly depending on what currency is being provided and the platform being used. Typically, cryptocurrencies have yield values of around 3% - 10% while stablecoins lie in the range of 7% - 15%. The reason for this disparity in yield is multi-faceted but in essence: stablecoin lenders are being compensated more for facing greater risk than fiat lending without the potential for huge gains offered by the high volatility of cryptocurrencies.

A platform is also required to facilitate the transaction and ensure a lending contract takes place as agreed. Different platforms allow for lending agreements to be made differently, but the key difference is whether they are ‘automatic’ or ‘manual’ platforms. By far the most popular type, automatic platforms such as Compound, MakerDAO, Celcius and Aave function similarly to an exchange in that they offer seamless functionality from both sides. Lenders and borrowers don’t interact directly, but rather operate through a meta-scale pool with proportionate compensations based on their contributions or loans automated by a smart contract.

Conversely, manual platforms such as CoinLoan function more similarly to a market place - with lenders and borrowers able to manually ‘post’ agreements of fixed terms to be signed. The platform in this case functions to facilitate compliance. If crypto lending however has so many of its fundamentals rooted in traditional lending, what’s fuelling its exponential growth in uptake?

What’s All the Fuss?

Unlike fiat, crypto lending poses unique advantages. One of the most significant obstacles for those seeking a loan has traditionally been the issue of being accepted to receive one. With crypto lending, prospective borrowers can avoid lengthy credit checks and application processes - making it significantly easier and faster to borrow.

From the lender’s perspective, profits have the potential to be much greater than those earned with traditional lending. Higher profits for lenders are associated with crypto lending for two main reasons. The first is that the inherent risk of lending volatile currencies allows for higher yields (or interest rates) for lenders. Lenders must be incentivised to lend in crypto currencies and stablecoins as opposed to more stable fiat currencies with lower comparative interest rates.

The second is that the volatility of cryptocurrencies themselves allows for enormous potential gains for lenders. Theoretically, market fluctuation could cause a borrower’s ETH-based 50% stake to rise in value above the actual value of the loan itself. This however raises the issue of the risks associated with crypto lending.

The Danger of Digital

Just as the volatility of crypto can benefit a lender’s earnings - it can also do the inverse. Cryptocurrency-based staking of loans can be highly risky for lenders as its value can fluctuate hugely. This in turn compromises the security of the stake - the very purpose of which is to secure the lender’s ability to recover their losses. One might argue that this risk is mitigated by the associated high yield values, but that too is most often based in crypto currency or stablecoins - it's a fragile ecosystem that has the capability to collapse.

The stability of the platforms which facilitate these loans is also worth consideration. In the case of automated platforms such as Celsius which act as intermediary liquidity pools - disruptions to the stability of the platform would have significant implications for both lenders and borrowers using the service. Today(30th Sep) it was discovered that a bug in Compound’s smart contract had resulted in $80m of rewards being sent to lenders in error: (https://www.theblockcrypto.com/linked/119086/compound-bug-comp-risk-misreward?utm_source=twitter&utm_medium=social).

Many also hold concerns surrounding the legal stance of financial institutions and its impact on platform stability. In the last two weeks alone, Texas financial authorities announced they would be pursuing action against Celsius for offering unregistered securities, and Coinbase withdrew plans to release its crypto lending platform ‘Lend’ after warnings from the US Securities and Exchange Commission. The stratospheric rise of the crypto lending space has not gone unnoticed by financial authorities.

From any perspective however, it is undeniable that crypto lending is causing quite a stir in DeFi and TradFi worlds alike. Digital currencies are making lending more accessible than ever and allowing it to take place in ways that are not possible with traditional currencies. If anything should be taken from this, it is that the future of crypto lending is still uncertain - for better or worse.

Find out more about deploying capital in the crypto space at https://novuminsights.com/

Rob Henderson - Novum Insights

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