By Mauricio Di Bartolomeo, co-founder of Ledn
For any new asset to perform similarly to traditional money, users must be able to perform all of the same financial services that they are already used to.One of the most important services is the ability to lend to earn passive income or borrow in a time of need.For as long as money has been around, so have lending markets.This remains true today, even in light of new digital currencies such as Bitcoin.
Bitcoin has seen lending platforms pop up over the years, but many of them have subsequently collapsed.Indeed, Sam Bankman-Fried has been found guilty for his role in one of the most infamous financial fraud cases in US history.The failure of these platforms can be attributed to opaque business practices enabled by a lack of oversight and internal risk management.Moreover, with the environment that free stimulus cheques and zero interest rates created, end-users had little regard for doing diligence on how the yield they were getting paid came from — everyone was in a mad dash for profit.
This environment allowed terrible people to do bad things.
Operators had little safeguards like ring-fencing of risks to separate lending operations from other products and services, and there was little to no way for clients to understand or keep tabs on how companies were operating.
The industry’s largest operators were standing on the shakiest footing — and when one domino collapsed, the others followed shortly after.Regulated financial services in the US would have had the Federal Reserve backing them as a “lender of last resort,” but without such backstops in place, nothing was there to stop the contagion.
This is why the digital asset lending space needs an overhaul.
A new model that is resilient and can stand on its own two feet without depending on bailouts from bigger businesses or the government.Once we can establish that framework, the industry can mature, evolve, and be taken as seriously as traditional finance alternatives are today.
Building Better Lending Markets For Bitcoin
Lending offers multiple benefits to financial markets.The most obvious one is the passive income earned by those who lend.This is a major incentive that drives these ecosystems, and the Bitcoin market is realistically no different.Lending is a force that reduces volatility and brings greater price stability to the market.Market makers will always seek to profit off of price discrepancies that appear across different exchanges, and this practice will reduce the bid-ask spread across all platforms.
In addition to generating yield for lenders, lending also helps bitcoin derivatives markets to operate smoothly.
It is ultimately a positive thing for all retail investors who benefit from added liquidity and less volatile spot markets.The fact is, without lending, Bitcoin would struggle to escape its “Wild West” nature, as without lending, a lot of the infrastructure and liquidity that the market needs would not exist.
Despite these benefits, the recent events outlined showcase significant issues that remain.One of the critical points that needed to be addressed is how platforms and operators lumped the risk of all of their business operations together.Regardless of which product a client was using, they all carried the same risk of failure as the operator.
In other words, clients with assets in a company’s “wallet” had the same risk and faced the same bankruptcy process as the clients who had willingly opted to lend their assets to earn yield yet still agreed to take that risk.That’s not how it should be.
To compound this problem, there have been serious issues surrounding the concentration of lending assets as well.This means that too many of these services only had one counterparty that could pay them the rates they offered their retail clients, and they lent way more than they should have to one group.When this happens, companies exceed the parameters of what can be safely lent to one counterparty.
Companies that do this tie their fate to that of the counterparty, as any loan impairment would be too much for the operator to absorb under a model with no “backstop” or external bailout.
This brings us back to why transparency is essential.Customers need to know how their assets are being used, where liquidity is coming from, and the overall standing of those providers.This is precisely what was missing from recently collapsed firms, such as BlockFi and Voyager Digital .Investors believed things were going fine behind the scenes, but there was no real ability to confirm this.As it turns out, overexposure to high-risk investments from too few sources was precisely the downfall of these businesses, something anyone could have seen coming if their operations weren’t opaque.
It Doesn’t Have To Stay This Way
Fortunately, the digital lending market in 2023 is evolving and working to address the outlined shortcomings in a variety of ways.There are options that anyone can utilize today for complete control and transparency over their money.
For one, more and more platforms are experimenting with a “two-account” system for their lending services.What this looks like for clients is a “safe” account where they can store their digital assets in a way that is completely separate from any risky investing, as well as a “growth” account that offers more sizable APYs, but is ring-fenced so that clients are only exposed to the counterparties generating their yield.
This allows the user to stay in complete control and accept all responsibility for any benefits or losses.Anyone who opts not to put themselves at risk bears no financial burden for the losses of others, so the entire system stays fair for everyone.
Along with these types of accounts comes a broader systemic push for complete transparency across these companies.Given what we have seen happen recently, clients demand to know exactly how all funds are handled.Any service reluctant to provide proof of reserves will be seen as highly suspect and likely won’t attract a wide array of users.
Lastly, many of these platforms are also working to massively diversify their lending and borrowing strategies.No longer will lending activity concentrate on one or even a few sources.
Instead, many smaller loans will be spread across the entire ecosystem, significantly reducing the risk of any specific entity failing to fulfill its obligation.
Ultimately, it’s time for the digital asset lending industry to finally mature.We must learn and evolve from the events of 2022 so we don’t repeat the same mistakes.All asset holders need to look at the services they use and ask themselves: are they transparent? Do they let me stay in control of my money? If these answers aren’t clear, it may be time to look elsewhere.
Ring-fencing of risk, transparency, and diversification is necessary to bring this space up to par with existing traditional finance guardrails.By building this, we will get one step closer to realizing the dream of cryptocurrencies becoming a new and equally valid branch of the financial system.
About Mauricio Di Bartolomeo
Mauricio is the co-founder of Ledn , a digital currency lending company that prioritizes transparency and client control through new, innovative products such as DCNs and Growth Accounts.Ledn was the crypto industry’s first digital asset lending company to complete a Proof-of-Reserves.
Mauricio experienced the impacts of hyperinflation in Venezuela and saw how quickly money can lose all its value.In hopes that he could provide for his family in the future, he escaped the economic catastrophe through Bitcoin and went on to earn his MBA at Western University in Canada.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc..