Genesis Capital’s fall could transform crypto lending — not bury it

Is crypto lending dead, or does it just need better execution? It’s a question that was asked more urgently in the wake of Genesis Global Capital’s Jan. 19 bankruptcy. That, in turn, followed the demise of other prominent crypto lenders, including Celsius Network and Voyager Digital in July 2022, and BlockFi, which filed for Chapter 11 bankruptcy protection in late November 2022.

Unlike many traditional creditors, such as banks, cryptocurrency lenders are not required to have capital or liquidity buffers to help them weather difficult times. The securities they hold – cryptocurrencies – usually suffer from high volatility; When the markets plummet, it can therefore hit crypto borrowers like an avalanche.

Edward Moya, a senior market analyst at Oanda, told Cointelegraph: “The death of crypto lender Genesis reminded traders that there is still much more cleanup to be done in the cryptoverse. You don’t need exposure to FTX to go under, and that theme could continue for a while for many distressed crypto companies.”

In line with these comments, Francesco Melpignano, CEO of Kadena Eco, a tier-1 blockchain, expects to see “contagion from these meltdowns continue to reverberate this year and perhaps the next.”

“There is a failure in risk management”

Is crypto lending broken? That’s a question Duke University finance professor Campbell Harvey was asked recently. His response: “I don’t think so.” He believes the business model is still healthy and that there is room for it in future finance.

After all, many traditional loans today are over-mortgaged. That is, the security provided may be worth more than the loan, which is unnecessary from a borrower’s point of view and results in a less efficient financial system. Of course, the problem with many crypto loan transactions is the opposite – they are undercollateralized.

However, a safe middle ground can be reached if one applies professional risk management practices to crypto lending, Harvey, co-author of the book, said. DeFi and the future of finance.

He believes that the bankrupt crypto firms failed to plan for the worst market scenarios, and it was not for lack of knowledge. “These people knew the history of crypto,” Harvey told Cointelegraph. Bitcoin (BTC) has fallen more than 50% at least half a dozen times in its short history, and lenders should have made significant withdrawals—and then some. “It’s a failure of risk management,” Harvey said.

Crypto lending firms also failed to diversify their borrower portfolios by number and type. The idea here is that if a hedge fund like Three Arrows Capital (3AC) collapses, it shouldn’t take its creditors down with it. Genesis Global Trading lent $2.4 billion to 3AC – far too much for a firm of its size to lend to a single borrower – and currently has a $1.2 billion claim against the now insolvent fund.

A traditional lender usually performs due diligence on a borrower to check out their business prospects before lending money, with collateral often adjusted based on counterparty risk. However, there is little evidence that this was done among failed crypto borrowers.

What can explain this disregard for basic risk management practices? “It’s easy to start a business when prices are going up,” Harvey said. Everyone makes money. It’s easy to push worst-case scenario planning aside.

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The attraction of cryptoloans in good times is that they offer individuals or businesses liquidity without having to sell their digital assets. Loans can be used for personal or business expenses without creating a tax event.

Some suggest that we are now in a time of transition. Eylon Aviv, a principal at venture capital firm Collider Ventures, sees cryptocurrency lending as an “essential primitive for the growth of the crypto ecosystem,” but as he further explained to Cointelegraph:

“We are currently caught in transition limbo between centralized players [Genesis, 3AC, Alameda Research] which has a scalable solution with poor risk management and handshake agreements that go up; and decentralized actors [Compound, Aave] which has a resilient but non-scalable solution.”

Why DCG?

Genesis is part of the Digital Currency Group (DCG), a venture capital firm founded by Barry Silbert in 2015. It is the closest thing the crypto industry has to a conglomerate. The portfolio includes Grayscale Investments, the world’s largest digital asset manager; CoinDesk, a crypto media platform; Foundry, a Bitcoin mining operation; and Luno, a London-based crypto exchange. “A big question mark on everyone’s mind is what will be DCG’s fate?” Moya said.

If DCG were to go bankrupt, “a mass liquidation of assets could send a shock to the crypto markets,” said Oanda’s Moya. However, he believes the market doesn’t necessarily see a return to recent lows, even though DCG plays a big role in the crypto world. Moya added:

“Much of the bad news for the space has been priced in and a DCG bankruptcy would be painful for many crypto companies, but not game over for holders of Bitcoin and Ethereum.”

“It is rumored that [Genesis] bankruptcy was part of a plan with creditors, Tegan Kline, co-founder and chief business officer of software development firm Edge and Node, told Cointelegraph. Whether that’s the case or not, “the filing means that DCG and Genesis are unlikely to dump coins on the market, and this is one of the reasons why recently [market] price measures have been positive, said Kline.

Kline believes DCG may have sufficient resources to weather the storm. That depends “on how well DCG can separate itself from Genesis,” Kline added. “DCG has a valuable venture portfolio. On that basis alone, my bet is that it will likely survive either by raising external capital or providing some equity to creditors.”

A new wave of lenders

Apart from DCG, the crypto lending sector can probably expect some changes before the end of 2023. Harvey expects a new wave of crypto lenders to emerge, led by traditional financial firms (TradFi), including banks, to replace the now depleted ranks of crypto lenders. “Traditional firms with expertise in risk management will enter the space and fill the void,” Harvey predicted.

These banks are now saying to themselves something along the lines of, “We have expertise in risk management. These lenders got cratered and there is now an opportunity to step in and do it the right way, Harvey said.

“I totally agree,” added Collider Ventures’ Aviv, who believes TradFi could soon rush in. “Competition is well on its way for the very lucrative loan market.” The main players will be centralized entities such as banks and financial firms, but Aviv expects to see more players with decentralized protocols built on top of Ethereum and other blockchains. “The winners will be the consumers and users, who will receive better, cheaper and more reliable services.”

Shawn Owen, the interim CEO of SALT Lending, told Cointelegraph, “The rise of traditional financial firms in the crypto lending market is a development we saw coming, and it shows the growing mainstream acceptance and potential of this innovative industry.”

Few emerge unscathed

SALT Lending built one of the earliest centralized platforms to allow borrowers to use crypto assets as collateral for fiat loans. It has registered with the United States Financial Crimes Enforcement Network and has a history of third-party audits. Although it does not perform credit checks on borrowers, it does perform full anti-money laundering and know-your-customer verification, among other things. SALT Lending has nevertheless not emerged unscathed from the latest turmoil.

The firm froze withdrawals and deposits to its platform in mid-November 2022 because “the collapse of FTX has affected our business,” it said. Around this time, crypto securities firm BnkToTheFuture announced that it is ending its efforts to acquire its parent company, SALT Blockchain. SALT Lending’s consumer lending license was recently suspended in California as well.

The “pause” on withdrawals and deposits, as the company calls it, was still in effect early this week. However, a Salt Lending source told Cointelegraph that: “We are in the final stages of going through an out-of-court restructuring that will allow us to continue normal business operations. We will have an official statement on this very soon.”

Still, amid all the upheaval, Owen insists that with the right management, the practice of lending and borrowing crypto assets “can be a valuable tool for achieving financial growth and stability.”

Will more regulation come?

Looking ahead, Owen expects more regulation of the cryptocurrency lending sector, including measures “such as the implementation of capital and liquidity buffers, similar to those required by traditional banks,” he told Cointelegraph.

Some practices such as remortgaging, where a lender reuses collateral to secure other loans, may come in for closer scrutiny. Owen also expects to see more interest in “cold storage” loans, “where borrowers can monitor their money throughout the loan period.”

Others agree that regulation will be on the table. “DCG’s debacle has [had] an incredibly damaging effect on institutional investors, which also means private investors will feel the brunt of it,” Melpignano of Kadena Eco told Cointelegraph. “I would liken it to a one-two punch that will give regulators the ammunition they need to move aggressively against the industry.” He added:

“The bright side is that the industry finally has a catalyst for clear rules to enter the space – entrepreneurs will need regulatory clarity both to build tomorrow’s use cases and attract institutional investment.”

“A Poisonous Substance”

Perhaps it is too early to ask, but what lessons have been learned from the bankruptcy petition on 19 January? The Genesis bankruptcy “reinforces the narrative that crypto lending should happen in a transparent manner in the chain,” Melpignano said. “For as dire as the situation may be for the industry in the short term, on-chain lending protocols were unaffected by all of 2022’s unfortunate events.” In his view, this solidifies the use case for decentralized finance – a more transparent and accessible financial system.

“If there’s a core lesson to be learned from last year, it’s not to idolize and rely on ‘thought leaders’ and ‘talking heads,'” Aviv said. The industry must push for “maximum transparency and audibility.”

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“High leverage is the most toxic drug in finance, not just in crypto,” Youwei Yang, chief economist at crypto miner Bit Mining, told Cointelegraph. This is probably the most important lesson, but the need for better risk management protocols is also now clear. People have learned to “loosen the standards under hyped [up] Market conditions could be a disaster after liquidity pulls out, Yang added.

Stronger and “better prepared”

Aviv says crypto lending will survive the crypto winter “and come out stronger through the other side” by using on-chain assets “that enforce and facilitate both audibility and regulation.” He expects continued innovation in this area, including “new forms of security such as real-world assets, transparent custodians, and enforceability via new account abstraction primitives.”

Overall, cryptocurrency lending remains a useful financial innovation, but practitioners need to embrace some of the state-of-the-art risk management practices developed by traditional financial firms. “The idea is good, but the execution was a failure,” summed up Duke University’s Harvey. “The second wave will be better prepared.”