Unkept promises: Crypto lending and its unrealistic risk-filled returns
Many crypto lenders are collapsing worldwide, here’s a look at why that is
May 2022 saw a continuation of the hostile events threatening the crypto market's existence. The collapse of stablecoins like TerraUSD and Luna, totalling $60 billion (Dh220 billion), revealed a new type of bank run.
For those new to the scene, TerraUSD is one of the most popular US dollar-pegged stablecoin projects and was intended to be the future of money. It was expected to maintain a constant value of $1 (Dh3.67), but it continues to dive below $1.
So far, the entire crypto edifice appears more precarious. Bitcoin went below $21,000 (Dh77,134) before recovering, Ether dipped and risks another decline, and since June, the whole market capitalisation of cryptocurrencies has fallen below $1 trillion (Dh3.67 trillion).
Consequently, investors and cryptocurrency buyers attempting to amass a fortune in this unpredictable market continue to be impacted by the string of dismal market performance. The effect is felt on both the demand (among investors) and supply (crypto dealers) sides.
Crypto lenders collapse worldwide
For the supply side, I refer to embattled and troubled crypto lenders here – companies like US-based Celsius and Voyager Digital, Singapore-based Vauld and Babel Finance, Seychelles-based CoinFlex, among others.
The model of crypto lenders fosters a departure from how most individuals would trade their assets or just ‘HODL’ – buy and hold cryptocurrencies despite volatility – to grow their capital.
Crypto lenders enable depositors to earn interest on cryptocurrency deposits and secure loans for borrowers with cryptocurrency collateral. It functions without a central institution. As long as the requirements outlined in the conditions of vesting a smart contract are met, securing a loan in cryptocurrency should not be difficult.
Crypto lending platforms may be centralised or decentralized, and lenders may obtain extraordinarily high annual percentage yields of 15 per cent or more, depending on the platform and other variables.
All of this makes crypto lending appear to be too good to be true.
Volatility aggravates crypto lending risks
Crypto lending can be an attractive option for both lenders and borrowers, but recent volatility in crypto lending highlights the enormous risks associated with this industry.
Currently, a number of the leading crypto lenders are in a precarious position and are choosing drastic measures to avoid insolvency — they have halted all withdrawals, trading, and deposits on their platform, while others, such as Vauld, are exploring potential restructuring possibilities.
Celsius is collapsing, has suspended withdrawals since June 2022, and has now filed for bankruptcy. Its demise is comparable to that of Lehman Brothers, whose collapse ultimately predicted the 2008 mortgage debt and financial crisis.
Voyager Digital, a lending platform with 3.5 million customers catering to retail investors with high-yield products, recently filed for bankruptcy as well.
Celsius and Voyagers Digital's demise may have been foreseen, and it can be summed up by the fact that crypto loans are inherently risky business. My reasoning for stating this is primarily because, as implied above, the cryptocurrency market is already highly volatile. It has never been stable, and just because it experienced a boom period does not preclude a subsequent downfall.
No insurance in place for crypto lending
In addition, unlike the traditional banking system, which usually protects client deposits, there are no explicit consumer protections in place to secure user funds if something goes wrong with a crypto lending transaction. As a result, customers can lose their deposits if the crypto lending platform fails, is hacked, or loses its customers' funds.
Not only that, but some lenders also make exaggerated interest rate promises. For example, Celsius offered as much as 18 per cent yearly interest on consumer funds until the day it froze them.
It stated: "By depositing crypto coins, you may earn interest rates as high as 18 per cent, which are tens or hundreds of times higher than rates on conventional savings accounts."
Moreover, the crypto lenders that collapsed should have been prepared with sufficient planning for market collapse scenarios. Why did these businesses not plan for such circumstances? What is the contingency plan if the market declines?
Some crypto lenders' lending policies are not stringent enough, and some lack risk management, resulting in a weak internal system.
Are all crypto lenders not trust-worthy?
Nevertheless, lenders such as UK-based Nexo and US-based BlockFi, who adhere to a more stringent lending policy and practice careful risk management, have not been implicated in the issue. That's because Nexo and BlockFi are both centralised systems that have included Know Your Customer (KYC) and anti-money laundering regulatory measures to mitigate risk.
Furthermore, although crypto borrowers who may not be eligible for a bank loan can obtain a loan from credit lenders without a credit check, the lack of oversight and credit regulation increases the risk of default compared to conventional loans, which are frequently federally insured.
The majority of these lenders are overly ambitious and may distort financial data. Ex-employees and internal records indicate that Celsius' reckless pursuit of significant returns have left it poorly positioned to withstand this year's market volatility.
Regardless of the gloom surrounding crypto lending and lenders, the Celsius episode and others provide a reality check. It could be an opportunity for crypto consumers and investors to distinguish between the platforms with a core value proposition and a solid internal system unaffected by the ups and downs of the cryptocurrency market and the ones that are merely empty promises.
It also begs the question of whether it is time to reveal government control and oversight to prevent such turmoil and whether we should seriously consider investor protection mandates in this market. Finally, the event also reiterated the significance of risk assessment and management systems.