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.

  1. Of course, we have workarounds to upgrade smart contracts, but they are just that, workarounds. Once a smart contract is deployed, it lives forever.
  2. A completely decentralized VC organization. Approximately $70M was stolen from the organization because of a smart contract bug.

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