Crypto-backed loans are in the process of becoming mainstream, with many companies already offering products and traditional banks set to follow. In this blog, AMPLYFI’s co-founder Chris Ganje explores the current landscape of crypto-backed loans.
Robinhood restricts GameStop trading just as the market skyrockets. The Greek government sets a 60 Euro ATM withdrawal limit during the 2015 debt crisis. Currency platform Wise freezes money transfers to Russia due to international sanctions. In each of these examples, our most common financial instruments have suddenly stopped working or been restricted. It turns out that we can withdraw cash from our own bank accounts on Sundays simply because the regulator allows us to. The reason most of us continue to use traditional banking and financial services is our trust in central authorities and high street brands. But if we start to lose this trust, what will we turn to?
The advent of Web3 and its focus on decentralisation could remove regulators completely. In the world of decentralised finance (DeFi), it is possible to recreate any traditional financial instrument, but with one major advantage – its execution is guaranteed by code and not dependent on the will of the parties involved. From this perspective, trust is baked into the process and regulators are not required. If we continue to lose trust in our financial institutions and their ways of working, then there is no fundamental reason why DeFi will not become mainstream.
Currently, the DeFi field is dominated by new and emerging crypto startups offering various instruments ranging from loans to outright gambling. With an annual growth rate exceeding 40%, it won’t take long for traditional banks and other financial institutions to enter the space and add web3 products to their mostly web2-based portfolios. What might their participation look like in the unchartered waters of DeFi?
Lending with Crypto as Collateral
One prominent area is lending. While lending crypto assets is not a significant market today due to low liquidity, crypto-collateralised loans in fiat currency are a totally different story. There are several compelling reasons why someone may choose to get a loan against their crypto assets rather than sell them. First, the value of crypto assets may increase over time – just think about selling your bitcoins for $10 back in 2014. Second, selling crypto assets may attract serious tax liabilities, most notably capital gains tax. In addition, if we are talking about high volumes of specific assets, trying to sell them all in one go may undermine the price achieved. The list goes on. Most notably, lenders do not need to perform credit checks as smart contracts and distributed ledger technologies ensure ownership and seamless transfer of the collateral to the lender in the event of loan default.
The market for crypto-collateralised loans is in its infancy with new players emerging. Coinbase, a major crypto exchange, started offering loans up to $1 million in late 2021. Figure Technologies launched its crypto-backed 30-year mortgages for up to $20 million in April 2022. Several banks, including Silvergate and Signature, have also joined the party. There are unconfirmed rumors that Goldman Sachs is seriously considering crypto-backed loans. At the time of writing, there is no reliable estimate of the market size, but indicators suggest it will accelerate in the near future.
While fairly similar to traditional loans, crypto-backed loans have some distinctive features. The interest rates for such loans are relatively low by crypto standards as they are backed with collateral. For example, Coinbase charges 8%, Figure Technologies sets rates in a range of 3% to 6%, and BlockFi offers loans at rates from 4.5%. As the value of the crypto collateral is rather volatile, lenders tend not to provide loans for more than 50% of the current value of the asset. Coinbase limits it to as low as 40%. Furthermore, if the value of the collateral drops dangerously close to the amount of the loan issued, the borrower may be asked to top up their collateral to maintain their loan.
To avoid the risk of liquidation, some platforms allow loans to be taken in the same cryptocurrency as the collateral. One such platform, Alchemix, goes as far as offering self-liquidating loans for same-currency loans. Essentially, it uses the collateral to generate a yield that covers both the interest on the loan and the principal amount. In essence, the loan self-liquidates over time. Curiously, the main cost to the borrower in such an arrangement is not the interest but the opportunity cost of not using the collateral themselves.
This is just a glimpse into the opportunities enabled by web3 for the finance industry. Other innovative but nascent ideas are emerging, and I look forward to discussing them in future posts.