Crypto-backed lending: How IT IS changing the eternal problem of seizing colLATERAL

The reason why crypto products are flourishing is because they solve real needs. Currently, given the low-interest environment, households and investors are looking for yield. At the same time, micro, small and medium enterprises (MSMEs) and individuals in emerging markets are unable to obtain credit because often their judicial system does not allow seizing collateral in a timely manner. Some interesting crypto companies are being able to connect both worlds with zero percent of default risk, opening new possibilities.

Photo source: Pexels.com

In the traditional financial system, households normally put their money in the bank and earn a certain interest rate. The problem is that in the past years there has been an erosion of interest rates. For example, deposits in savings accounts the United States currently yield 0.05% APY[1], which is one fourth of the rate from 2009. This low interest environment expands to government bonds and prompts institutional investors to look for alternative asset classes to increase the yield in their portfolios.

Currently, there is a need for yield for households and investors, given the lower interest rate environment. At the same time, MSMEs have problems accessing loans especially in emerging markets

Furthermore, as reported by the World Bank, access to finance is a key constrain to MSMEs growth. Globally, there is a finance gap of USD 5.1 trillion and approximately 2 billion adults lack access to financial services. Some of the reasons for this lack of access are the impossibility or delay for lenders to exercise the collateral, and the lack of existence of a legal system where movable collateral (inventory, accounts receivables, crops and equipment) is accepted (versus immovable collateral, which is land and buildings)[2].

In the past, companies have tried to disintermediate the banks to obtain the interest spread. A few years ago, crowdfunding platforms were created to provide individuals a higher rate for their deposits by lending these funds to small and medium business. However, examples like Lending Club showcase that getting institutional capital effectively make these businesses more sustainable and efficient, and consequently, there is only partial disintermediation[3].

Companies have tried to disintermediate the banks in the past to obtain the interest spread but only managed a partial disintermediation

Now, a similar disintermediation movement is happening in the crypto space but with enhanced capabilities. One of the first movers was BlockFi, a company that offers interest-bearing deposits accounts and term loans with cryptoassets as collateral. The main difference between BlockFi’s business model and other crowdfunding solutions, apart from using cryptoassets, is that BlockFi’s loans are overcollateralized (50% loan to deposit ratio) reducing non-performing loans ratios to zero. In addition, crypto is an exercisable collateral globally and does not depend on the efficiency of the local judicial system where the lender is located. Many of BlockFi clients are market makers, investment funds and crypto business, but there is increased demand from countries whose currencies are not stable or whose judicial processes to exercise collateral may take years. This has led to an incredible growth of the company not only among US customers but also abroad. As of 2020, it manages more than USD 1.5 billion of assets under management.

Crypto collateral can be exercised instantly regardless of the local judicial system. This allows more disintermediation and expands possibilities of loans where traditional collateral could not be exercisable (e.g. emerging markets)

Other important companies providing overcollateralized lending and interest-bearing deposits for crypto are Nexo, Crypto.com, Ledn, Celsius Network, CoinLoan, etc. Some of these have created their own utility token (NEXO, CEL) to incentivize usage and enlarge the community and the pool of funds. These tokens normally offer credit line discounts and higher interest rates on savings to holders. However, until real peer-to-peer lending is large enough many tap into long-term liquidity from larger banks to lower lending rates.

Still, obtaining liquidity from larger banks may be partly desirable for certain companies now since it helps lower lending rates till the peer-to-peer lending market is large enough

According to BlockFi CEO and Co-Founder Zac Prince, the international market for US dollar lending is USD 11 trillion and it is currently only constrained to governments and large corporations. Consequently, and given the high demand of US dollar globally beyond these two actors, it is foreseen that the US dollar lending market will increase. However, it is expected that currencies of other major and minor currencies will be tokenized as stablecoins and will be used as collateral for lending.

In conclusion, crypto-backed lending companies are bringing solutions to real current problems of consumers, companies and investors. Some of these problems such as the inefficiency of the judiciary processes to exercise collateral or low interest rates did not have a clear solution in the short-term, but crypto is bypassing these old constrains and making possible products that were impossible before. The current crypto-backed lending companies are paving the way to new ways of understanding finance, and these initial activities are just a first step.

[1] https://www.fdic.gov/regulations/resources/rates/ [2] https://www.worldbank.org/en/topic/financialsector/brief/collateral-registries [3] https://debanked.com/2019/02/peers-are-almost-gone-from-lending-clubs-funding-mix/