Crypto lending business – greed, gloom, and doom

Crypto lending business – greed, gloom, and doom

Dimitrios Goranitis, FSI Risk & Regulatory Advisory Partner, Deloitte Central Europe

The crypto market has not yet stop growing, counting new cryptocurrencies every day, big swings, whipsaw/scams, and even new features, such as crypto lending, that can permanently change the whole crypto game. For many centuries coins and banknotes were borrowed and lent by banks from people who saved to people who wanted to invest and create new businesses. The crypto market makes use of the very
same principle, with people who have already accumulated a significant amount of coins in their wallets and, driven by the desire to gain a passive income, are open to lending coins to others who may speculate or aim at increasing their position in other coins.
The request for this new feature is massive, with a significant number of users asking for its implementation, mainly given the attractiveness of the interest rate for deposits. From a cost opportunity point of view, deposit rates in the US and Eurozone are very low, close to zero, however on the crypto market they could be considerably higher, i.e., on some crypto platforms bitcoin deposit is up to 8.5% p.a. and for others stable coins is up to 14% which easily surpasses many asset classes.
However, crypto market is not sufficiently regulated. Therefore, in February, Block Fi, one of the biggest platforms for crypto trading, was agreed to settle with SEC to pay 100$ million for selling its crypto-lending product without registering it as a security. In September 2021, Coinbase could offer the same product using USDC as currency for gaining interest but ultimately, they settled with SEC to cancel the intention. If crypto trading is here to stay, SEC does not seem to be quite keen on lending, the 100$ million fine being a signal for other players and the market to understand the importance of lending and its associated risks. But what about banks? What do these platforms i.e., Coinbase, BlockFI, Celsius, etc. manage to offer to their clients to the detriment of a bank?

Basel Committee proposed a 1250% RW on crypto-assets exposures
In the first half of 2021, Basel issued a consultative document on crypto-assets exposure, classifying them in two groups (group 1 and 2) based on four conditions (tokenized and stabilisation mechanism, legally enforcement, network, and entities involved). Although Basel treats credit risk and market risk for all these assets, there is still no differentiation between the trading and banking book and the intention is to also have operational risk charge add-ons calculated.
Nevertheless, none of the aforementioned groups are considered to be an eligible form of financial collaterals for the purpose of recognition as credit risk mitigation under SA for credit risk. Therefore, they are not qualified as eligible high liquid assets (HQLA) either from a liquidity perspective, but for leverage ratio and large exposure they will follow the same principles.
Last but not least, computation for RWA differs from group 1a to 1b and 2, a harsh 1250% RW is applied for group 2 (as a maximum between absolute short and long position held in crypto-asset) which is equal to a 100% loss in the capital. For group 1b, equity investment in fund approach is applied to take into consideration CRE and MAR, therefore banks could apply the same three methods: LTA, MBA, and FBA (the
flatter implies a 1250% RW).

Coinbase comments – the voice of the crypto market
The consultation paper is closed since September, having received a significant number of comments, many from banking associations, several commercial banks, national banks, a couple of technology companies, and one crypto platform. It is worth mentioning Coinbase’s response, a document with over 25 pages that addresses many of the aspects included in the consultative documents and aimed at explaining the reasons why the platform is in disagreement with Basel principles.
The boundary between the banking book and trading book is the first point tackled in Coinbase’s response, as to make a differentiation between assets held to maturity and held for sale. For trading book, applying SA-SBM (Sensitivities Based Method), the highest RW is 80% for equities that’s why Coinbase creates different scenarios under SBM assuming empirical and conservative correlations) which results in a lower capital charge in the proposed response.
The next aspect addressed is the eligibility for financial collateral. Under 1-day VaR 99% and 10-days VaR 99% for the biggest crypto assets, the results showed that some equities in S&P600 small cap (i.e., GME, STMP, NOV, APA) recorded higher VaR than these crypto assets, while Basel considers these equities as collateral eligible with a 15% haircut.
Coinbase’s response includes several other points relating to the classification between-group 1a, 1b, and 2, AML-CFT-KYC aspects, punitive 1250% RW instead of 400-600% and to the operational risk add-on that should be integrated into Pillar 1, similar to digital mobile when it was implemented. Other comments received from Ripple Labs, Bitcoin Association Switzerland did not beat Coinbase’s comprehensive response and analysis, which is why it would not be an exaggeration to consider Coinbase’s response as the voice of the crypto market at this moment in time.

Conclusion and future steps
Driven by the higher interest rates obtained for a deposit compared to traditional banking deposits or sovereign bonds, the urge for crypto lending is undoubtedly present on the market. Nevertheless, having in mind the corresponding supervisory considerations, as well as the so called “crypto market view” the risks associated with this new feature of the crypto-market (in terms of credit, market, operations collateral,
counterparty and so on) are not difficult to identify. In addition to the banking risk, from a point of view of a wholesale bank, there are also risks that needs to be considered in what concerns the customer.
The crypto-coins in the deposit are not under deposits guarantee scheme, which means if a counterparty defaults the coins will not be returned to the owner, while in EU zone under DGS any deposit under 100,000EUR is safe and will be returned to the customer. Moreover, there is also the risk that coins may disappear or be stolen; a significant number of such occurrences can be recalled, the most recent and
striking example having happened just last summer and counting no less but 600$ million.
In what concerns collaterals, having a coin backed by another coin is very risky especially when market is down, and the tendency among people is to liquidate their position. It could also be the case of any real money, as well as an underlying or traditional asset, as Basel refer to, which consequently raises other issues.
There is no doubt that crypto lending is highly desired on the market, however it comes along with significant number of risks that one should be very cautious about. A net has been created around this product for so many years through Basel accords, so that one could “play with fire” if the implications and risks are not fully understood. Although, everyone is looking for high return and low risk (free lunch), it is of
utmost importance to be compliant with the regulatory framework in place, otherwise the consequences might be severe, just as it was the case of BlockFi and the fine it received from SEC.
May the future be bright and less volatile for the crypto market, with reduced frauds, money laundering and stolen coins. Only then, it will enjoy more trust form the side of the banks and regulators. For now, we are still looking at a market under development and not mature enough for the big league… but nonetheless advancing at a fairly high speed.