As per an article by Bloomberg, another credit bubble is growing – the crypto loans market. However, the bubble may burst soon owing to the lack of robust lending standards and high risk. While this seems to be the case with the lending economy created by centralised crypto companies, the rise of smart-contract based lending protocols in the DeFi economy may help turn around the state of affairs in the crypto loans market.
The Bloating Crypto Loans Bubble
The crypto loans market, just 2 years old, is now worth a whopping $5 billion. The market sprung after the ICO bubble burst in 2018 and the price of digital assets came crashing down. People who did not want to sell their crypto holdings at low prices. That is when the idea of lending crypto to earn interest or use as collateral to borrow cash emerged, and it quickly burgeoned into a market worth billions of dollars.
While this market has opened new opportunities for credit, it doesn’t come without its own share of problems. A group of former Wall Street traders believes that this market has grown too quickly and it is heading towards a blow-up. The market is characterized by relaxed lending standards and high risk, and these two major issues are a cause of concern for many stakeholders of the crypto market.
Alex Mashinsky, the founder of lending platform Celsius Network feels that institutions with strong compliance and risk management procedures do not pose a risk to this market. Instead, the risk comes from unsophisticated individual traders holding highly leveraged crypto derivatives.
However, it is to be noted that even institutions are not infallible, as can be deduced from the 2008 Economic Crisis which top US banks and other major Wall Street institutions were involved.
Jason Urban, the CEO of Drawbridge Capital in Chicago says –
“What keeps me up at night is not adoption, or even regulatory uncertainty: it’s credit risk… the torpedo below the waterline is an MF Global-Lehman Brothers type event.”
While some centralised crypto lending companies have established strict rules around crypto loans, others have not. Zac Prince, the CEO of BlockFi claims that his firm follows strict standards and therefore, it has never experienced a loss or even a late payment. On the other hand, there are companies like Nexo which are playing with fire by encouraging “under-leveraged” borrowing where the loan-to-value ratio is no greater than 50%.
While this crypto credit bubble burst might not even cause a ripple in the global credit economy, it will depress the prices of digital assets further, which might lead to an exodus of users from the cryptocurrency ecosystem.
Can DeFi Save the Collapsing Crypto Loans Economy?
DeFi lending protocols, while they perform the same function as centralised crypto lending companies, are entirely different in terms of how they work. In DeFi lending protocols like MakerDAO and Compound, the terms of lending are embedded in a smart contract and the value of collateralization for the loan is always greater than the loan value.
If the value of the collateral falls below a certain level, then the borrower has to pay some form of penalty or their tokens given as collateral are automatically unlocked and liquidated in the open market.
When the borrower returns the principal amount of the loan along with the interest, their collateral is returned back to them. Many lending protocols also allow users to lend their own cryptocurrencies and earn interest on them.
All the processes in DeFi lending protocols are controlled by smart contracts, so every process gets executed as per the rules. Since the level of collateralization is always higher than the loan value, the risk of non-repayment is already covered. Thus, cryptocurrency holders get to avail the maximum benefit from their crypto holdings. The risk of non-repayment is also covered by the collateral they give.
Thus, DeFi might be able to save the crypto loans economy from collapsing after all.
“DeFi is the answer. [It has] Way more transparent, and much more collateral. Businesses have been making bad loans for about ten thousand years – that’s nothing new”
says Robert Leshner, founder of Compound.
Compound, at present, ranks second on DeFi Pulse, a tracker for DeFi projects. At present, the total value locked in Compound is over $115 MM.
Lending Protocols make over 80% of total value locked in DeFi projects. There is over $500 MM in total value locked in lending projects. However, the issue with DeFi lending projects is that they only make a small fraction of the crypto loans economy as yet – 10%. DeFi protocols need to overtake centralised lending to cause disruption.
The good news is that the change is happening, gradually. The total value locked in DeFi projects is on the rise. DeFi has grown over 300% in a year. On November 7, DeFi hit a new all-time high of 3.475 MM in total value locked.
It would be reasonable to expect that DeFi projects will grow further as the crypto community starts to recognize the value propositions offered by them. Perhaps, they will initiate the next massive bull run or they might even bring about the crypto flipping if we think optimistically.