Risk in Crypto Lending

By Robert Walker Cohen

The crypto lending space is growing. Very fast. The space is broken down into three sectors:

  1. DeFi
  2. Consumer lending
  3. Institutional lending

DeFi stands for “decentralized finance”, i.e., financial services that are managed by smart contracts. Once they’re deployed, humans are out of the loop. 

Consumer and institutional lending in crypto is very similar to traditional lending, although the properties of crypto leads to some interesting outcomes.

As money pours in, people are starting to call DeFi blockchain’s “killer app” and cash is pouring in. Private (centralized) crypto lending is benefiting from this inflow.

Of course, where there’s money there’s risk. And where there’s cutting edge technology, there’s even more risk. Let’s look at the biggest risk each sector faces.

DeFi

DeFi protocols (platforms) are made up of a collection of smart contracts. Smart contracts can’t be patched1. In DeFi, smart contracts deal with tokens that have value. Sometimes these contracts process thousands, tens-of-thousands, and even hundreds-of-thousands of Dollars worth of value. Mistakes (bugs) can have disastrous consequences. That’s a big risk.

As a result, DeFi firms have been working hard to demonstrate the integrity of the code in their contracts. Lucrative bug bounty programs and consistent auditing by companies such as Open Zeppelin, Trail of Bits, Certora, Peckshield and many others, provide in-depth and transparent analysis of smart contracts and have proven to be invaluable to the DeFi industry. 

Compound in particular has become the standard bearer for consistent security audits and, as a result, has become the bedrock on which other protocols are building their products.

With security breaches like The DAO2 still fresh in people’s minds, implementation and widespread acceptance of these security measures will continue to be crucial.

Private Consumer Lenders

Consumer lenders are worried about one thing: getting their money back!

When a consumer lender makes a loan they have two ways of making sure the loan is repaid:

  1. Collateral.
  2. Reputation.

Collateral against a loan can be seized if a loan isn’t repaid. It’s usually a safe way to mitigate the risk of someone not paying back their loan.

A credit score is a reputation indicator and enforcement mechanism rolled into one. Lender extend credit based on a borrower’s credit score. If a borrower fails to pay back a loan, the lender can damage the borrower’s reputation by reporting data that will lower their credit score. In a lot of places people have a very big incentive not to damage their score.

In crypto, credit scores don’t exist, although several companies (including us!) are working on it.

Without credit scores, collateral is king. 

The biggest problem with most collateral is liquidity. A property is collateral for a mortgage, but if the house falls below the value of the mortgage, the bank loses money.  And if no one wants to buy the property, the bank ends up with a property (instead of cash!) on its balance sheet.

Crypto collateral turns out to be highly liquid, so private consumer lenders take very little risk it turns out. It’s a great business, if we can continue to grow the market.

Private Institutional Lenders

Institutional lending is nothing like consumer lending. Institutions are known entity. Someone at institution “x” is bound to know someone at institution “y”. And of course there’s a lot of data out there about companies. So when institution “x” lends to institution “y”, where’s the risk?

Thinking that they’re “good for it” because you know their CFO, Joe, doesn’t mean they’re good for it. Thinking that they’re “good for it” because everyone knows they’re a rock-solid company, doesn’t mean they’re good for it. Familiarity is not a good proxy for credit data. 

Many institutional lenders do careful analyses of their counterparties’ financials, but in crypto that doesn’t always help. Crypto institutions tend to have a lot of cryptocurrencies on their balance sheets. How they got those tokens (loans? leverage?) is hard to determine. In fact, those tokens may be collateral against a loan. Unraveling these obligations is difficult. There are no regulations and there are very few experts. We don’t know of any institution in the crypto space that has that expertise in house. 

And that’s a big risk.

What is DeFi?

In the past few months I’ve been to three conferences at which participates couldn’t agree on a definition of DeFi. 

Here’s an example, from a DeFi conference 😳

This sort of ambiguity won’t do, at least not in our context. 

Here at Graychain we talk about DeFi all the time. We analyze DeFi data, we build DeFi tools, and we publish reports that cover DeFi. Needless to say, we have a very clear understanding of what we mean by DeFi!

For us, 

DeFi includes any financial service that is not designed to require a central authority. 

That definition gives us a lot of latitude, but easily excludes any traditional financial that happens to process digital assets. In other words, we adhere to the “small tent” definition of DeFi, while acknowledging that true De(centralization) is aspirational. 

If DeFi is a spectrum, how do we decide when something is NOT DeFi?

  • If a service is regulated, it’s not DeFi.
  • If a service is not managed by a smart contract, it’s not DeFi. 

Simple. Now let’s look at some examples.

If Compound DeFi?

Yes. It’s globally accessible, doesn’t KYC, and can’t be shut down by any state regulator. The Compound service is encoded in smart contracts.

Is BlockFi Interest Account (BIA) DeFi?

No. BlockFi is regulated. 

Is Binance DEX DeFi?

Yes. Although Binance itself is regulated, its DEX isn’t

We are clearly focused on credit, which means that we work with projects / companies in the lending space. The biggest DeFi lenders are:

  • Compound,
  • Maker,
  • dY/dX, and 
  • nüo.

None of them are completely De(centralized), but they aspire to be, which is all we can expect at this point in history.

Anonymous Secured Lending

“There’s no way anonymous lending can work.” – Anonymous

“Anonymous lending won’t happen any time soon.” – Anonymous

“The future is faster than you think.” – Peter Diamandis, Co-Founder, Singularity University

True cryptocurrencies allow us to exchange value across any distance, without a middleman, and without permission. A little over ten years ago, this wasn’t possible. Today, a whole range of sophisticated financial services are being built on top of this extraordinary new infrastructure. Crypto lending services are now common.

People have invested heavily in cryptocurrencies, hoping that they’ll be worth significantly more in the future. If you’ve acquired crypto for that reason, you aren’t in a hurry to sell it, even though some fiat liquidity might be useful. For that reason, many crypto owners are using this asset as collateral to take out fiat or stablecoin loans, using a financial instrument called a Collateralized Debt Position or CDP.

The origin of CDPs

CDPs have only existed since 2014. They are managed by smart contracts1 that allow anyone to deposit a digital asset as collateral against a crypto loan. The borrowers and lenders may be anonymous. The borrowers and lenders may or may not be people. They may be people, corporations, or smart contracts2.

CDPs were popularized by the MakerDAO (“Maker”) project. Maker allows Ether3 holders to mint Dai, a stablecoin4, by pooling their Ether. They can remove up to 66% of the value of their Ether in Dai, and can get it back by paying back the Dai, removing it from circulation. In the token world, this is called “Burning” a token. Dai can be exchanged for fiat currency, thereby providing fiat liquidity to anyone who locks up their Ether.

The birth of an ecosystem

CDPs are now considered a critical financial product in the crypto world. Maker’s ideas were quickly imitated, with many variations. Many other distributed projects and companies now issue fiat and crypto loans, secured by crypto. Some of these, such as Compound and Dharma, are completely anonymous and automated. Others, such as Nexo and SALT, are custodial5 and require KYC/AML6. Much of the industry’s lending volume is still conjecture, but our early estimates from media, self-reported volume, and publicly available data puts the volume of loans originated at about USD 3.4B.

Lending Anonymously

Anonymity is one of the foundational features of blockchain transactions. Maker, Compound, and DyDx are totally autonomous. No personally identifiable information is asked of lenders or  borrowers. This presents unique opportunities, as well as challenges. 

Currently, these platforms require that customers over-collateralize their loans, so they can only borrow up to 66% of their crypto’s value. This allows the platforms to make sure that if the price of the collateralized asset drops, the collateral can be seized (with fees) before the value of the collateral drops below the value of the loan. This protects lenders, but also makes the product less appealing to potential borrowers. Lenders are currently seeking ways to safely lower the necessary amount of collateral without increasing their risk. Since the borrower is anonymous, the tools to do this need to rely on historical data associated with a borrower’s wallet address.

The future, it turns out, is now.

What will Happen in the DeFi Lending Area: Credit in Crytpo and its Huge Market Potential

Coin Tokyo Article

If you read “Traditional Credit – A Primer” you know all about how traditional credit works. You don’t actually, but you know enough to take a plunge into the increasingly-strange world of crypto credit.

The Distant Past

Once upon a time (3 years ago), very generous VCs and ICO investors gave some enterprising startups money to start unsecured lending businesses. Some, like BTCJam went out of business,while others, like Ripio changed their business model . These startups tried all sorts of clever ways to make sure people paid back their loans. Most of them didn’t. The investors’ money disappeared. 

The Recent Past

From the ashes of these early failed experiments rose today’s DeFi Lenders. You’ve probably heard of some of them:  SALT, Compound, Dharma, dxdy, Cred

These guys are doing pioneering work. They’re allowing crypto holders to leverage those assets to borrow more crypto or fiat (via stablecoins). This is pretty great if you’re convinced your crypto is going to go up in value, or just need cash without incurring a capital gain.

Although collateralized lending is not new, these companies are introducing all sorts of innovations into the process. This is thanks to the nature of crypto. Because of its recent volatility, stablecoins are often part of the equation. Because many of the transactions are managed by smart contracts that can react to data in real-time, contract parameters can be more flexible than they are traditionally. Since blockchains aren’t shut off on weekends, contracts can liquidate or settle at any time.

Despite the innovation, the companies building and managing these loan platforms are taking almost no risk. If the value of crypto looks like it will drop below the value of the outstanding loan, or if the borrower fails to meet the repayment terms, the lender liquidates the collateral and still makes a profit. 

Unfortunately, there’s a downside to not taking any risk. These companies are leaving money on the table.

Today

Today there’s a lot of planning going on, and it’s exciting.

The current batch of DeFi lenders are working to reduce the amount of collateral they have to hold and to increase the amount of time they can comfortably wait before liquidating a loan. Both of those will increase their profit margins. 

They’re also working on increasing their exposure to lenders’ behavior, thereby requiring even less crypto as collateral. They will replace crypto with reputation. This will be possible thanks to the availability of crypto credit data. As a result crypto lenders will enjoy the same dynamics as non-crypto lenders who rely on both hard assets and credit bureaus to mitigate the risk of delinquent borrowers.

But today’s DeFi lenders aren’t alone. Lots of companies are quietly planning their move into crypto lending.

The Near Future

Anyone with a background in financial services knows how critical a healthy credit market is to the whole financial system. Most of the people in today’s DeFi space have that background.

Anyone holding digital assets is going to want to lend them out. That’s how traditional banks make money, and that’s how digital custodians will make money. 

Crypto credit data is going to allow a flood of new entrants into the lending space.

Today, crypto lending is primarily a trading strategy. People leveraging their assets in this way are very sophisticated. The use of crypto for day-to-day transactions is growing and will continue to grow. In parallel we will see a demand for more traditional loans, both partially-collateralized and uncollateralized. The supply for this demand will be waiting. Volumes will surprise everyone.

The (slightly less) Near Future

One very interesting property of crypto credit data is that it’s associated with blockchain addresses, not people. This has two unexpected implications.

First, it means that loans can be made anonymously. If an address has a positive credit score, does it matter if we know who’s behind it? Absolutely not. This type of lending won’t be possible in a lot of jurisdictions, but the world’s a big place, and you can bet your bottom dollar that a lot of lenders in the future will be jurisdictionless. Some will be completely autonomous.

And speaking of autonomous, besides a person’s wallet, what else can you find behind a blockchain address? A smart contract. Who’s to say that smart contracts won’t need to borrow money from time to time? If a contract has a good reputation, shouldn’t it be able to? No such contract exists yet, but it’s easy to imagine a dapp in a supply chain needing short-term liquidity to bridge a transaction.

I did mention that things were going to get strange, didn’t I?

From Zero to One (Trillion)

Today, the traditional financial system issues trillions of dollars of loans every year.

Dozens of companies in the crypto space are in the process of building out the infrastructure required to issue loans on a similar scale. That would be exciting enough, but the story won’t end there. Thanks to the unique properties of cryptocurrencies, we are going to see the emergence of never-before-seen credit products that will support use-cases we can’t even imagine today. 

One trillion is a certainly a low estimate.

About Graychain

Graychain is the world’s first crypto credit bureau. It was founded in 2018 after the founders built a peer-to-peer lending platform that they never launched. They never launched it because they needed credit data, and it didn’t exist.

Graychain is based in Hong Kong with personnel in the US, South-East Asia, Europe, and Africa.

About Paul Murphy

Mr. Murphy is one of Graychain’s founders and its CEO. His career in the software industry has spanned over twenty years and four continents.  

The first ten years were dedicated to understanding and building large systems on Wall Street for clients like J.P. Morgan and Salomon Brothers. Mr. Murphy’s work in this area allowed him to explore a broad range of computing solutions.

After 9/11, Mr. Murphy moved to London to work at Adeptra, a pioneer in the use of automated outbound calling in the area of credit card fraud detection and prevention. The systems Mr. Murphy developed made extensive use of text-to-speech and voice recognition technologies.

Exploring the intersection of telephony and computing eventually led Mr. Murphy to found Clarify, a pioneer in speech recognition and natural language processing, both of which make extensive use of AI.

Graychain is Mr. Murphy’s fifth startup. He firmly believes that cryptocurrency-based financial systems will transform the world in ways that will surprise, frighten, and delight us all.

What will Happen in the DeFi lending area, A Primer: Traditional Credit and its Importance

Coin Tokyo Article

Why Credit Matters

Credit is the most boring topic in finance. It’s also the most exciting. 

Credit is boring when it exists, invisibly, as part of the fabric of a financial system. In places where this is the case – like Japan – only the absence of credit would be exciting, exciting the way natural disasters are exciting. In places like Japan and the US, credit is institutionalized.

In other parts of the world, like many countries in Africa, Latin America, and South-East Asia, institutional credit barely exists. Sometimes it doesn’t exist at all. People there can’t buy homes or cars on credit and they can’t take out loans to start a business. Countries without institutional credit, however, tend to have very well-developed informal (or social) credit systems. In India, it’s not unusual to tell a shopkeeper that you’ll pay him tomorrow for the milk you are bringing home today. Imagine doing that at a 7-11 in Tokyo.

All credit removes friction from people’s lives. Informal credit allows people to buy milk even if they don’t have enough money on hand. Institutional credit allows people to buy a car even if they don’t have enough money on hand.

Credit is a critical lubricant in any financial or social system.

But what is Credit?

Credit is Trust.

The shopkeeper in India knows the person who has taken his milk without paying. The shopkeeper (lender) knows that the borrower lives in the neighborhood, he knows how the borrower has behaved well in the past, and he knows the borrower’s friends and acquaintances. These social connections make it highly likely that the borrower will eventually pay for the milk. This “social credit” guarantees the loan.

When credit is institutionalized, that social element doesn’t exist in that way. Even if your banker knows you, the bank’s shareholders don’t. How then can they trust that you will repay a loan without a social guarantee? Very simply, in exchange for lending you money, they hold on to something you don’t want to lose, either an asset, your reputation, or both. The asset – which we can call collateral in this case – is given to secure the repayment of the loan. In English, that means that if the loan isn’t repaid, the borrower gets to keep the asset. If you borrow money to buy a house, the bank gets to keep the house if you don’t make contracted payments. This is called the liquidation of a loan. The collateral is sold for cash to recover the money lent. 

Collateral therefore acts as an enforcement mechanism for the repayment of the debt. Simple, but, unfortunately, not enough in a lot of cases.

What happens if the property market crashes between the time you take out a loan to buy a house and the time the bank realizes that you aren’t going to repay it? They may then be unable to liquidate the house for anywhere near the amount of money they lent you to buy it. 

So what else can an institutional lender get from a borrower to secure a loan? Something very similar to what the shopkeeper in India has: the borrower’s reputation.

Reputation as Collateral

Reputation is precious, and it is most precious to its owner. Its loss can be devastating.

The shopkeeper can destroy someone’s reputation by telling the community that one of its members doesn’t honor their debts. Once that’s known, the individual in question is unlikely to be offered credit by other merchants.

Institutional lenders, without the social network, essentially have the same power. They have it thanks to the credit reporting and scoring systems that exist in every developed economy. 

The mechanism is simple:

  1. Lenders report their clients’ behavior to credit bureaus.
  2. When an institution is asked to extend credit, they ask the credit bureau for a summary of the potential borrower’s past behavior. 
  3. The credit bureau summarizes that behavior into a credit score. 

Someone with a low credit score is unlikely to:

  • get another loan, 
  • be given a post-pay phone contract, 
  • be able to rent a home, and even
  • be able to get certain jobs. 

Loss of reputation in the form of a low credit score can be devastating.

This is how credit works traditionally, but what happens in the crypto space?
For the answer to that question, read “Crypto Credit – From Zero to One Trillion”.