The advent of cryptocurrency backed loans will have profound ramifications on the crypto markets. Although several exchanges and credit companies have tried to enter the space, none of them have achieved market dominance.
The idea for cryptocurrency backed loans has existed for a while. Many ICOs have successfully raised money for the idea, and currently, there are several dubious companies operating in the space. Additionally, there are also a number of smart contracts that allow for decentralized lending on the Ethereum blockchain.
That said, none of these services have gained considerable traction. The obstacles to establishing a reputable lending company are many, and consequently, the industry will either need to consolidate or wait for a large player to enter the market.
However, once there is a major player these cryptocurrency collateralized loans would have a profound impact on cryptocurrency investors and users. These services would increase market liquidity, make obtaining crypto easier, and decrease the transaction costs of acquiring crypto.
How Crypto Collateralized Loans Work
Crypto loans work by utilizing a deposit of Bitcoin, Ethereum, Ripple, or another major cryptocurrency as collateral. Prior to obtaining a loan, a borrower is first assessed for creditworthiness. Oftentimes, a borrower’s credit score, demographic data, and online activity are assessed to determine creditworthiness. The score obtained from this data determines the loan’s interest rate and the ratio of collateral needed for the loan.
Then, a borrower deposits cryptocurrency and receives a fraction of its value in fiat or another asset. Depending on whether the issuer of that fiat is an organization or an individual determines whether the loan is peer-to-peer (P2P) or a conventional institutional loan.
These collateralized loans are an important service for cryptocurrencies. A robust credit industry around crypto-collateralized loans would benefit adoption and reduce the complications associated with owning crypto. If a reliable, well-regulated crypto-credit industry existed it would benefit users in three main ways:
- Reducing Tax Burden
- Providing Trading Leverage
- Easing Crypto to Crypto Conversion
Reducing Tax Burden
Taxes under U.S. Generally Accepted Accounting Principles (GAAP) and globally recognized International Financial Reporting Standards (IFRS) are a major concern for cryptocurrency users. Transactions such as exchanging one cryptocurrency for another, or using cryptocurrency to purchase a good or service trigger capital gains and losses.
In the United States, the tax on short-term capital gains is a whopping 30 percent. Many other countries have capital gains taxes around this figure. By using an intermediary lender a user can prevent these taxes.
If someone borrows fiat using cryptocurrency as collateral, purchases made with that fiat do not incur capital gains or losses. Furthermore, such lending allows crypto holders to spend fiat while waiting for long-term capital gains to apply to holdings. In the U.S., if cryptocurrency is held for a year or more as an investment, then those gains are given favorable tax treatment with a 10 percent long-term capital gains tax.
Providing Trading Leverage
Another benefit of cryptocurrency collateralized loans is margin trading. Margin trading is the practice of borrowing funds against a financial asset, such as stocks or crypto, to amplify gains or losses from market movement.
Many major exchanges like BitMex, Bitfinex, Poloniex, and Kraken already offer margin trading. However, the terms of this service can oftentimes be predatory, with high collateral requirements, exorbitant interest rates, and unreliable service.
Access to loans can provide another mechanism for margin traders to gain additional leverage. A competitive market for these loans would mean lower interest rates and lower collateral requirements.
Easing Crypto to Crypto Conversions
The final benefit of collateralized loans is easing of trading friction. Trading friction occurs when it is difficult to directly exchange two assets with limited liquidity, or when the costs of trading one asset into another are high.
An example of trading friction is when someone is trying to purchase an obscure altcoin using another altcoin; because the liquidity in such markets is low, then the spread on such a transaction is high, meaning higher trading costs.
To circumvent these issues, most users first convert into an intermediary such as Ethereum or Bitcoin before trading into the other alt-coin, but this trade also incurs its own costs.
Lending services can ease trading friction. Furthermore, some players in this market are exploring crypto to crypto loans. These loans would allow a user to borrow one cryptocurrency against another. For example, using Bitcoin as collateral to borrow Ethereum.
These kinds of loans would increase the liquidity of these markets and consequently decrease transaction friction. However, to have a noticeable impact on trading friction these services would need to gain more traction.
Risks with Collateralized Loans
Although these kinds of loans offer a solution to some of the inconveniences of crypto, there are also a number of risks involved. First, margin calls on a loan from price volatility can penalize a borrower. Second, crypto-related lending is ripe with Ponzi schemes and scams, and finally, regulators can disrupt legitimate firms in the industry.
Given the volatility of cryptocurrency, every time there is a drop in prices there is the possibility of a margin call. A margin call happens when the value of the deposit decreases and the lender needs additional collateral or requires the lender to sell existing collateral, to cover potential losses.
Many cryptocurrencies that would be used as collateral for these loans are extremely volatile. Even if the price tanks for a fraction of the second it would still trigger a margin call and liquidate some, or all, of a borrower’s collateral.
Potential for Scams
As highlighted in a TechCrunch exposé, between one-third and one-fourth of the 3500 crypto-backed lending platforms in China were either Ponzi schemes, were involved in police investigations or made it difficult for users to withdraw deposited funds.
These findings are not limited to Chinese lending platforms. Lending around cryptocurrency is ripe for scams, especially peer-to-peer lending. Oftentimes, these companies operate on the fringes of the law and take advantage of the decentralized nature of crypto. When these unscrupulous companies go out of business those that suffer the consequences are often the users.
If a loan provider were to default, or worse yet, steal user deposits, then borrowers usually have limited recourse given that these companies usually operate out of countries with loose regulations.
On the other end of the spectrum, regulators themselves are also a risk to this industry. Entering major markets such as the United States, Europe, China, or South Korea require an enormous investment in legal compliance.
Through the introduction of new regulation, or the more stringent enforcement of existing regulation, regulators can seriously hamper lending companies. As much as regulation is necessary for a fair and trustworthy credit market, regulation can also be an impediment for legitimate firms.
The Future of Lending
Cryptocurrency collateralized loans are a valuable service in the space. These loans would lessen the tax burden, increase the ease of trading, and reduce the cost of conversion for cryptocurrency users.
The market is ready for a legitimate firm to enter the industry. Whether that entrant is an ICO that achieves break-out success, an incumbent crypto company like Coinbase entering the space, or a traditional player such as Square Inc. exploring loans, the industry is waiting for a reliable source of credit.
As the industry matures around cryptocurrency, its uses and utility will rise with it. At its core, the price of any technology is tied to the value it provides its users. Financing and credit is just one more value-add application.
Cover Photo by Noah Glynn on Unsplash