the central theses
- Crypto lenders provide returns on crypto deposits like stablecoins by lending them at interest – similar to traditional banking practices
- Crypto lending platforms fall into two main categories: non-custodial (decentralized) and custodial (centralized).
On June 13, 2022, Celsius investors woke up to an alarming statement from the crypto lending platform: “Celsius is suspending all withdrawals, exchanges, and inter-account transfers.”
For a platform that prides itself on its high returns without the hassles of traditional finance, many wondered, “How does crypto lending really work and where has all the liquidity gone?”
What is crypto credit and how does it work?
Let’s start with the basics. On the surface, crypto lending works just like traditional banking, but for digital assets. Crypto lenders provide returns on crypto deposits like stablecoins by lending them out at interest. The main difference lies in the type of deposit and the type of lender.
There are two very distinct categories of crypto lending platforms: non-custodial (decentralized) and custodial (centralized) platforms. Non-custodial lending is a new approach, while custody lending uses the traditional model with minor differences. Celsius is an example of the latter. To understand why there are problems with the custodial lending model, we need to explain the differences in liquidity raising and collateral requirements.
Crypto Loan Categories Explained
Custodian (centralized) crypto lending
Custody crypto lending looks and feels like a cryptocurrency bank — without the same regulatory oversight and consumer protections. It manages all deposits and loans on a central platform and internal balance sheet. Those looking to earn interest on their crypto savings send their tokens to a custody wallet address, where they lose direct control of the asset. In return, the platform invests the assets at its discretion – be it through lending at interest rates or through alternative yield farming.
Non-custodial (decentralized) crypto lending
A non-custodial lending platform enables decentralized peer-to-peer or peer-to-pool lending. Unlike its traditional counterpart, it allows depositors (lenders) to retain ownership of their tokens – and the source of revenue is clear. Lenders earn interest and borrowers pay interest. Using blockchain smart contracts, platforms can automate functions traditionally managed by banks or custodians.
Crypto Liquidity Defined
Crypto liquidity, like in traditional markets, is the efficiency with which any digital asset can be converted into cash or a tokenized equivalent – with no impact on the market price. Think of total asset liquidity as a water supply and asset price as the water level. The larger the pool, the slower the level changes.
Stock markets traditionally measure liquidity in cash, but crypto markets measure it using an ever-growing list of token pairs. It can be difficult to follow this web, but it is important to do so in order to understand how crypto lending platforms maintain liquidity.
Where and how crypto lending platforms are sourcing liquidity
Non-custodial (decentralized) crypto lending
Decentralized crypto lenders like Aave raise liquidity through a network of different liquidity pools. So instead of lenders and borrowers setting the terms of their peer-to-peer loans, the protocol uses automated smart contracts to set interest rates for each pool.
Aave’s liquidity pool protocol aims to incentivize external lenders to keep pools liquid and borrowing functional.
For example, when an Ether pool (ETH) is low on liquidity, these smart contracts will automatically raise interest rates to attract lenders to that pool and encourage borrowers to repay their loans. When lenders add ETH, they get the tokenized equivalent of Aave in the form of aETH. This asset differs from a wrapped token as there is no central custodian. Smart contracts hold ETH deposits and automatically reward the lender with lending rates.
Custodial Crypto Lending (Centralized).
In contrast, centralized crypto lenders like Celsius draw liquidity from their centrally controlled pool of total deposits. They manage interest rates and approve loans on a case-by-case basis. Unlike decentralized non-custodial lenders, centralized lenders generate income from multiple sources in addition to interest payments. For example, Celsius invests customer deposits in something called liquid staking.
Liquid staking (stETH)
With ETH staking on Ethereum’s Beacon Chain locking ETH until a later date – not yet set, but likely in mid-2023 – post-merger Lido Finance is offering stETH, a liquid derivative for ETH holders interested in staking rewards are. The token allows holders to collect staking rewards but retains the flexibility to sell or transfer the asset. If they trade the token with someone else, the new owner can claim future staking rewards. Nansen Research reported that Celsius owns a wallet of over $450 million worth of stETH.
Differences in collateral requirements for crypto loans
Crypto Collateral is the pledging of tokenized assets or currency by a borrower to a lender in case the lender is unable to repay the loan. The borrower retains ownership of the security as long as the loan is repaid with interest.
Traditional banking typically requires a small portion of the loan as collateral and uses the borrower’s credit rating to gauge credit risk. As crypto lending prides itself on providing quick loans with no minimum credit rating, liquid collateral is required for liquidations to be automated. So instead of using your home as collateral, you would have to use stablecoins or other cryptoassets — although perhaps in the future it will be easier for anyone to tokenize property. Because crypto markets are extraordinarily volatile, lenders are demanding a lower loan-to-value (LTV) ratio (not to be confused with Total Value Locked, or TVL).
I know there’s a lot to grasp – so let’s review:
LTV – A loan-to-value relationship is the share of collateral in the value of a loan. An LTV ratio of 100% corresponds to a 1:1 ratio, which means that the borrower is posting the full value of the loan as collateral.
TVL – Total Locked is the total value of cryptocurrency locked in a smart contract and represents the health and liquidity of a decentralized exchange or crypto lending protocol.
Both crypto loan categories require a high LTV, but differ in how they measure, report, and enforce liquidations.
Custodial Crypto Lending (Centralized).
Centralized lending can use different methods to monitor LTV. If a borrower’s LTV falls below the safety threshold, the centralized lender issues a margin call to warn the borrower that some of their collateral may be liquidated. If the value falls further, the lender automatically initiates partial or full realization of the borrower’s collateral.
However, with centralized lending, this collateral requirement does not directly protect depositors. As centralized lenders switch deposits between different assets like stETH and stablecoins like Tether (USDT), depositors have little visibility into all the liquidity available on a centralized platform.
Celsius’s announcement of suspending withdrawals on June 13, 2022 increased selling pressure on stETH, pushing the price further below ETH’s price. Many speculated that this divergence prompted Celsius to freeze accounts. However, since their total liquidity value is not public, it is not possible to assess what triggered the fear.
Non-custodial (decentralized) crypto lending
Decentralized lending, on the other hand, is completely transparent. Any liquidity provider can look up a platform’s TVL to measure overall liquidity and health. There are no alarming tweets indicating that the core team has suspended withdrawals. There are oracle pricing and smart contract risks, but decentralized lending is not inherently subject to the risks of a central custodian.
For example, when a lender deposits ETH into an Aave ETH liquidity pool, smart contracts make the liquidity available exclusively to ETH borrowers. No central authority can withdraw the deposit and play with it outside the chain.
Blockchain price oracles constantly monitor each borrower’s LTV ratios, so if there is a risk of default, the protocol automatically liquidates collateral to protect the lender.
Liquidity Risks in Crypto Lending
There are liquidity risks in both credit categories. With decentralized lending, price oracles can fail in market-wide liquidity stresses, exposing liquidation to price erosion and lenders recovering only a portion of their deposits. And with centralized lending, key players can leverage customer deposits at the risk of draining too much liquidity from the platform.
In fact, the liquidity issues on one side of the crypto lending world often hurt the other side. This contagion results from a complex interplay between wrapped tokens, staked ETH, and stablecoins on decentralized exchanges like Curve Finance.
Subscribe to the Blockworks newsletter for updates and explanations on the impact of the crypto lending contagion inside and outside the digital asset markets.
Corrected this article to say that “lenders require a lower loan-to-value (LTV)” rather than a higher LTV. In DeFi, a lower LTV means tighter collateral requirements.
Receive the top crypto news and insights of the day via email every night. Subscribe to Blockworks’ free newsletter now.
Want Alpha delivered straight to your inbox? Get ideas on Epee trading, governance updates, token performance, must-see tweets and more from Blockworks Research’s daily debrief.
can’t wait Receive our news as soon as possible. Join us on Telegram and follow us on Google News.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.