The landscape of institutional lending within the crypto sector is undergoing a notable transformation, presenting wealth managers with new opportunities to leverage digital assets as collateral. This resurgence is reminiscent of the traditional practices of collateralized lending that have roots dating back to medieval Europe, yet now it is adapted to fit the unique properties of cryptocurrencies.
Wealth managers must recognize that lending and borrowing have always played pivotal roles in financial ecosystems. In the context of cryptocurrency, the introduction of collateralized lending predated the rise of Decentralized Finance (DeFi) platforms. Historically, the concept known as Lombard lending involved using various financial instruments, including movable goods and securities, as collateral for loans, setting the stage for today’s digital asset lending market.
A key advantage of utilizing crypto as collateral lies in its liquidity. Major cryptocurrencies can typically be traded around the clock, allowing for quick access to market capital. This liquidity coupled with the speculative nature of digital assets fuels a demand for leverage. Additionally, in some tax jurisdictions, securing loans against crypto can yield benefits, enabling liquidity generation without resulting in immediate taxable events. Therefore, it is not uncommon for long-term Bitcoin holders—who are often hesitant to divest their BTC—to opt for low loan-to-value (LTV) ratios, betting on the asset’s potential appreciation in value over time.
The history of collateralized crypto lending dates back to the early days of Bitcoin, with informal lending practices emerging in 2013. However, the onset of the Initial Coin Offering (ICO) boom in 2016-2017 saw the advent of more structured lending entities, such as Genesis and BlockFi. Despite the setbacks during the 2018 crypto winter, the centralized finance (CeFi) sector continued to grow, with companies like Celsius and Nexo enhancing their market presence.
The subsequent rise of DeFi between 2020 and 2021 created a competitive environment, as both DeFi and CeFi platforms vied for user deposits. However, the sharp uptick in competition led to deterioration in balance sheet integrity. Several lending platforms operated with compromising asset-liability mismatches and relaxed their criteria for loans, often supported by their governance tokens. This lax approach laid the groundwork for significant vulnerabilities within the sector.
The collapse of stablecoin TerraUSD (UST) and the hedge fund Three Arrows Capital (3AC) in 2022 highlighted these weaknesses, triggering a ripple effect across the lending landscape. Well-known CeFi entities struggled to fulfill withdrawal requests and faced bankruptcy, resulting in billions in lost customer assets. Regulatory investigations revealed recurring issues of inadequate collateralization, poor risk management practices, and lack of transparency regarding interconnected firm exposures. An investigative report on Celsius depicted a company that misrepresented its operational safety while engaging in questionable lending practices akin to “Ponzi-like” operations.
In the aftermath, the crypto lending sector has seen a recalibration. Remaining CeFi lenders are now prioritizing risk management, enhancing collateral requirements, and implementing stricter policies to mitigate risks associated with rehypothecation and inter-firm dependencies. Even with these improvements, the sector’s scale remains only about 40% of what it was at the peak in 2021.
As wealth managers navigate this evolving landscape, understanding the dynamics of collateralized crypto lending will be crucial. By considering the lessons learned from past challenges and recognizing the potential for structured, secure lending practices, they can position themselves to effectively incorporate crypto assets into their offerings.
